I had a very interesting conversation with a friend last night about diversification of risk.
The concept of diversification is most broadly understood in the context of investing in the stock market. Warren Buffet explained:
Diversification serves as protection against ignorance. If you want to make sure that nothing bad happens to you relative to the market, you should own everything. There's nothing wrong with that. It's a perfectly sound approach for somebody who doesn't know how to analyze businesses.
Buffet further explainsed that the unsophisticated, ignorant investor should:
. . . both own a large number of equities and space out his purchases. By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when "dumb" money acknowledges its limititations, it ceases to be dumb.
John Maynard Keynes mocked diversification, viewing it to be "as imprudent for [the ignorant investor] to make his own investments as to be his own doctor or lawyer." He explained his alternative view:
. . . my theory of risk is that it is better to take a substantial holding of what one believes shows evidence of not being risky rather than scatter holdings in fields where one has not the same assurance.I assume that Keynes really meant to say that the level of risk involved was acceptable. The guy understood there is always risk.
I'm a tweener when it comes to diversification as an investment strategy. I think you have to do it to a certain degree, particuarly at certain times, but I'd prefer to make informed, target bets. Given the extreme uncertainty in the market right now, and the increased difficulty in valuing any business in this economic environment, diversification alone is what I am doing (when I am in the market, which I am not at the moment).
But what about diversification when it comes to running a business? Should the leadership of a company diversify its risk by making multiple bets? I'd say it depends on what you mean by diversification in this context. If you mean making multiple, informed bets that you are passionate about and will relentlessly execute towards accomplishing in parallel (your efforts in one area cannot conflict with your efforts in another), then I'm all for it. But I don't think diversification as that term is understood in the investment context can or should be adopted wholesale into the business context because investing is passive and managing a business is active.
This leads me back to the concept of "iconic" words, words that mean different things to different people without those differences necessarily being recognized. "Diversification" is a word that is used both in the investing context and in the business context. I wonder to what extent people differentiate between their understanding and application of that term in the two contexts, if they do at all. I certainly differentiate, but I cannot assume that anybody else does. Although my experiences leads me to believe that most differentiate as I do, it only takes a few people who don't to obviate apparent agreement on how to proceed.
Let me explain.
In contract law, agreement is not reached unless there is a "meeting of the minds." If two people agree to do something, but each has a different understanding of what that something is (e.g., there are two ships named the Peerless, and one contracting party is referring to the first and the other party is referring to the second), then there is no contract, and there cannot be breach or liability for breach. This was the situation in the case of Raffles v. Wichelhaus.
In organizations, a failure of the meeting of the minds of the employees of the organization to drive the organization towards what they thought was a common goal (but actually isn't) does not free the organization from the consequences. Everybody is stuck with whatever result they get, which is why more time probably should be spent confirming that everybody really has agreed whenever their are multiple decision makers.
I'm sure there's a study of organizational dynamics that addresses this issue. Somewhere. Maybe I will try to find it
Monday, November 29, 2010
"Diversification" as an Iconic Word
Below is yet another "deposted" post from the old blog. Again, I'll explain why I'm bothering with this in a bit.