413. Diversification to reduce risk
Diversification is one of the most effective and widely used ways to reduce risk. There are many opportunities to diversify in agriculture.
Diversification means doing a combination of different business activities, rather than just one. It’s about not having all of your eggs in one basket.
Diversification can be attractive to farmers (or other business managers) who are risk-averse because it can reduce the riskiness of the overall business strategy.
If a farmer grows wheat in every paddock of their farm, there is minimal diversification, and any adverse event that affects the profitability of wheat production (e.g., a fall in sale price, poor weather conditions) could affect the farm’s entire output. On the other hand, if the farmer diversifies by growing some wheat, some barley, some oats, some canola, some hay, and some pasture to support livestock, the business is somewhat diversified, and risk is reduced to some degree.
The reason that diversification works to reduce risk is because of a lack of correlation between the different income-generating activities. If the market is bad for wheat, there is some chance that it won’t be so bad for livestock.
The lower the correlation between the activities, the bigger the reduction in risk from combining them. Best of all is combining activities whose profits are negative correlated: in a year when one activity is less profitable than usual, the other has a good chance of being more profitable than usual. In ideal circumstances, the risks from the two activities could go close to cancelling out.
More realistic in most cases is combining activities that have little or no correlation. That’s hard to achieve with different farming activities on the same farm, because the weather probably affects all activities in broadly similar ways. But it’s quite achievable if the farmer invests in non-farming business activities. That’s one of the reasons why diversifying into off-farm activities can be so attractive.
That observation highlights that risk should really be considered at an aggregate level (the whole farm business plus any non-farm income), not one small part of it (a paddock of wheat). In PD412, I wrote about risk from crop production as affected by fertilizers, but really, focussing on the riskiness of production in an individual paddock is not the right way to think about risk. It’s better to take a holistic perspective, recognising that risks from one paddock of a particular crop could be partly or fully offset by other production enterprises on the farm, or by cropping on another property some distance away (to reduce the correlation between crop yields), or by income from an off-farm investment. If so, the riskiness of profit from the individual paddock would be of little concern, even if the farmer is highly risk-averse.
Sometimes people look at farmers who have a diversified portfolio of activities and assume that it must be a response to the farmer being risk-averse. However, that is not necessarily the case, because there can be other non-risk reasons for combining different activities. For example, diversified crop rotations can have advantages in reducing crop diseases, or improving soil structure, or passing on legume-fixed nitrogen to cereal crops, or diversifying weed-control methods to delay the evolution of resistance to any one control method. It could also be that the farmer’s resource constraints (labour, machinery or finance) can be better managed by diversifying activities. All of these things are not primarily about risk, they’re about profitability (although they can contribute to risk mitigation as well, to some degree).
So, just observing that a farmer’s business is diversified doesn’t necessarily mean that the farmer is particularly risk-averse but it probably does mean that the overall riskiness of the farm business is relatively low.
Further reading
Pannell, D.J. and Nordblom, T.L. (1998). Impact of risk aversion on whole‑farm management in Syria. Australian Journal of Agricultural and Resource Economics 42(3), 227-247. Available here. “On the larger farm, the model suggests that risk-averse farmers adopt strategies which are much more diversified than their risk-neutral counterparts.”
Pannell, D.J. (1987). Crop‑livestock interactions and rotation selection, In: R.S. Kingwell and D.J. Pannell (Eds). MIDAS, A Bioeconomic Model of a Dryland Farm System, Pudoc, Wageningen, 64‑73. Chapter available here. This shows that diversification can be beneficial even without considering risk.
This is #7 in my RiskWi$e series. Read about RiskWi$e here or here.
The RiskWi$e series:
405. Risk in Australian grain farming
406. Risk means probability distributions
408. Farmers’ risk perceptions
409. Farmers’ risk preferences
410. Strategic decisions, tactical decisions and risk
412. Risk aversion and fertiliser decisions
413. Diversification to reduce risk (this post)
414. Intuitive versus analytical thinking about risk
Thanks Dave. This article had me thinking about diversity of risk attitudes and implications for regional agricultural economies. To some extent, variability in risk attitude among landholders may provide insulation against risks to a regional economy. Extension activities that advocate (explicitly or implicitly) for homogenised risk attitudes may inadvertently invite greater risk. Conceptually. I can’t think of an example, but maybe you can!?
Interesting comment Terry. I see what’s triggered this thought, but I’m not sure the two contexts are equivalent. For an individual, I’m assuming that their objective is to achieve a balance between risk and return (with the balance depending on how risk-averse they are). For an agency running an extension activity focused on risk, what would be an equivalent objective? A balance between the hetrogeneity of risk-aversion level and average-risk aversion level? It doesn’t seem like a meaningful objective. Maybe I’m missing your point?
Erm, I’m nought but a dabbler here. As you know!
Was thinking an extension agency or production adviser might generally encourage risk neutrality in (commercial) decisions involving what to farm. In the long run, this will maximise economic outcomes for the landholder and for the region. But in encouraging homogenisation of risk attitude there will tend to be a smaller portfolio of farm products across the region at any point in time, with the regional economy exposed to greater transient risk. For social stability (e.g. keeping schools and banks and shops and hospitals bubbling along) there may be an argument for satisficing rather than maximising economic outcomes. Here, an extension agency interested in social stability of regional communities might do well to encourage a diversity of risk attitudes, and its implications for greater diversity in farm products. So, there is a similar trade-off to the risk and return proposition for an individual. For the extension agency there may be a need to balance the risk of transient instability with the return of long-term economic productivity.
Hmm, OK, I see. My main reaction is that I don’t think an extension agency would ever do that. Risk aversion is a personal characteristic, like a tendency for optimism or anxiety. There’s no reason for an agency to want to influence that, and I’ve never seen one try. If they tried, they’d fail.
Maybe a situation that’s a bit like what you’re describing could be where an agency promotes adoption of a new crop variety that has a higher mean profit but also a higher standard deviation of profit from year to year. Farmers (and rural communities) might be even worse off than they would have been in the bad years. So there might be a social-welfare argument for promoting a different crop variety that is more stable-yielding, though less profitable on average.