Question

For each of the following scenarios, say whether pooling or diversification is a more promising riskmitigation strategy. [LO 11.6\(]\) a. Employees of a company who receive their salaries and health insurance from their employer and also invest their savings in that company's stocks. b. Families who are worried about losing their possessions if their houses burn down. c. Neighboring farmers who grow the same crop, which is prone to failure in dry years.

Short answer

a. Diversification, b. Pooling, c. Diversification.

Step-by-step solution

Understanding Pooling and Diversification

Pooling refers to combining risks from different sources to lower the overall risk through spreading. On the other hand, diversification involves spreading investments or risks across different areas to minimize exposure to any single risk.

Analyzing Scenario a

In this scenario, employees hold both their salary and investments with the same company. The risks are not spread across different entities; hence, if the company fails, both their income and investments are at risk. Diversification would be a better strategy here as it would spread investment risks across different companies or sectors.

Analyzing Scenario b

Families worried about losing possessions in fires would benefit from pooling through insurance policies. By paying premiums, risks are pooled with others and compensated in the event of a fire, even though not all houses will burn down at the same time.

Analyzing Scenario c

Neighboring farmers planting the same crop are vulnerable to the same environmental risks, like drought. Pooling does not mitigate this shared risk. Instead, diversification by planting different, drought-resistant crops could significantly reduce the risk of total crop failure.

Key concepts

Pooling

Pooling is a risk mitigation strategy where risks from different sources are combined. This approach spreads out risks by sharing them among multiple parties or sources. Imagine a group of people pooling their resources to buy insurance. Such pooling helps to dilute the impact if a negative event happens.

Insurance is a great example of pooling. When people buy insurance, they pool their risks with many others. In case someone needs to make a claim, the pooled resources are used for compensation. This way, the individuals manage risk through collective sharing.

• Combines risk from different sources.
• Spreads out risk to reduce individual impact.
• Used in scenarios like insurance.

Diversification

Diversification is the practice of spreading investments or risks across various assets or areas. It aims to reduce exposure to any single risk. By diversifying, individuals or companies can minimize the impact of a single poor investment or risk.

Consider a farmer planting different crops instead of just one. If one crop fails due to drought, others might thrive or at least survive, minimizing total loss. Similarly, in investments, owning a mix of stocks, bonds, and other assets reduces risk compared to investing in a single stock.

• Spreads risk across multiple areas or assets.
• Reduces dependence on one source.
• Common in investments and farming.

Insurance Policies

Insurance policies are formal contracts that pool risk by allowing you to pay a premium in exchange for financial protection against specific risks. These policies are vital tools for individuals and businesses alike.

When you purchase insurance, you agree to pay a regular fee or premium. In return, the insurance company promises to cover damage or loss from covered risks, like accidents or theft. By pooling with others through insurance, the risk of loss for any individual is significantly reduced, since the insurance company has collected premiums from many people.

• Involves paying a premium for coverage against certain risks.
• Pools risk with many others.
• Provides financial protection and peace of mind.

Investment Diversification

Investment diversification is a crucial strategy for managing financial risk. By spreading investments across various asset classes, sectors, or geographies, you can protect your portfolio from potential downturns in a particular market.

For instance, if you only hold stocks in one company, your financial outcome is tied to that company's performance. If it fails, you face significant losses. However, by investing in different companies, sectors, or even different countries, you lower your dependence on any single entity's performance.

• Reduces risk by spreading investments.
• Includes various asset classes, like stocks and bonds.
• Enhances portfolio stability during market fluctuations.