|Risks do not exist in isolation. An event that
may have an adverse effect on one financial asset
may have a beneficial effect on another. Risk should
be seen as affecting the overall returns of a group
-- or portfolio -- of assets.
A diversified portfolio has less risk
than its individual components -- so long as the
individual returns are negatively correlated.
What does this mean? Consider a two-member law
firm -- one lawyer practices securities law and
the other bankruptcy law. When the economy is
going great, the securities lawyer has plenty
of work and his bankruptcy partner attends CLE
programs. They share their fees, and both are
comfortable. When the economy takes a downturn,
the bankruptcy lawyer is flush with work and his
securities partner commiserates with his clients.
But again the lawyers are still comfortable --
they have reduced the risk their annual returns
will deviate from average since securities and
bankruptcy practice are negatively correlated.
That is, their practices are affected in opposite
ways by economic ups and downs.
Can diversification eliminate all risk? No. There
will always be an underlying systematic risk.
In our two-person law firm, there is the risk
that multi-disciplinary practice firms gain a
competitive foothold in their areas of practice
and law practice becomes devalued -- diversification
could not save them. This is just one of the unavoidalbe
risks of being in the lawyering market. Even if
the lawyers entered into a larger practice, or
entered into a wide-ranging MDP, there would always
exist inherent "systematic" risks that
no amount of diversification can eliminate.