(1) Diversification is based on the idea of ‘spreading the risk’, which relates to portfolio management. The total risk should be reduced as the portfolio of diversification gets larger.
(2) Risk can be diversified in terms of financial management and market/product management.
(3) Diversification only works where returns from different business are not positively correlated.
(4) Risks that can be diversified away are referred to as unsystematic risk. The inherent risk – the systematic or market risk – cannot be diversified away.
Risk avoidance vs. Risk retention
Risk avoidance and risk retention strategies relate in part to the risk appetite of the organization, and then the potential likelihood of each risk, and the impact/consequence of that risk.
(1) A risk strategy by which the organization avoids a risk. Organizations will often consider whether risk can be avoided and if so whether avoidance is desirable.
(2) A risk avoidance strategy is likely to be followed where an organization has a low risk appetite.
(1) A risk strategy by which an organization retains that particular risk within the organization. It is where the organization bears the risk itself.
(2) A risk retention strategy will be followed where the risk is deemed to be minimal or where other risk strategies are simply too expensive.
Risk Attitude and Necessity
(1) An organization’s attitude to risk is determined by its risk strategy, risk appetite and risk capacity. (a) the overall risk strategy determines the overall approach to risk; (b) the risk appetite determines how risks will be managed; (c) the risk capacity indicates how much risk the organization can accept.
(2) If the risk capacity has been reached, then the organization will tend to seek low-risk activities whereas risky projects may be undertaken.
(3) A high-risk appetite will indicate that the organization will normally seek a higher number of high risk/return activities whereas a low-risk appetite means a higher number of low risk/return activities preferred.
(4) The organization’s overall strategy is likely to have a portfolio of projects from which the overall risk appetite is met.
(5) A risk strategy of primarily self insurance, which implies risk minimization as an overall strategy, may limit the organization’s strategy regarding undertaking risky projects.
Necessity of risk
(1) Incurring an acceptable amount of risk tends to make a business more competitive whereas not accepting risk tends to make a business less dynamic.
(2) Incurring risk also implies that the returns from different activities will be higher. The benefits can be financial or intangible, which both will lead to the business being able to gain competitive advantages.
Risk attitude and organization
In general, a small, young company may have a higher risk appetite as it takes risks in order to get its product into the market whereas a larger, older company may appear to be more risk adverse as it seeks to protect its current market position.