In Practice Who should diversify The Firm or Investors

As we noted in the last section, the exposure to each type of risk can be mitigated by either the firm or by investors in the firm. The question of who should do it can be answered fairly easily by comparing the costs faced by each. As a general rule, a firm should embark on actions that reduce risk only if it is cheaper for it to do so than it is for its investors. With a publicly traded firm, it will usually be much cheaper for investors to diversify away risk than it is for the firm. Consider, for instance, risk that affects an entire sector. A firm can reduce its exposure to this risk by either acquiring other firms, paying large premiums over the market price, or by investing large amounts in businesses where it does not have any expertise. Investors in the firm, on the other hand, can accomplish the same by expanding their portfolios to include stocks in other sectors or even more simply by holding diversified mutual funds. Since the cost of diversifying for investors is very low, firms should try to diversify away risk only if the cost is minimal or if the risk reduction is a side benefit from an action with a different objective. One example would be project risk. Since Disney is in the business of making movies, the risk reduction that comes from making lots of movies is essentially costless.

The choice is more complicated for private businesses. The owners of these businesses often have the bulk of their wealth invested in these businesses and they can either try to take money out of the businesses and invest it elsewhere or they can diversify their businesses. In fact, many family businesses in Latin America and Asia became conglomerates as they expanded, partly because they wanted to spread their risks.

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