WFU Law School
Law & Valuation
2.3 Risk of Multiple Assets (Portfolio Risk)

2.3.1 Portfolio Theory

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.

 
2.3 Risk of Multiple Assets (Portfolio Risk)

©2003 Professor Alan R. Palmiter

This page was last updated on: August 4, 2003