■This article proposes a probabilistic approach to project operational risk and project portfolio risk diversification. The analysis rests on a fundamental distinction between a fractional and an additive approach for constructing portfolios. Since the additive approach excludes variance as a measure of risk, the project's operational risk is defined by its probability of loss. Paradoxically, the effectiveness of any firm's portfolio risk diversification process will be negatively related to the operational risk of its representative project. We also present the conditions under which risk management and efficiency management can contribute to the firm's strategic imperative of lowering its operational risk.
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This article proposes a probabilistic approach to project portfolio risk diversification. Risk analysis techniques dealing with single capital investment projects have, to a certain extent, largely been misleading in a number of ways. First, limiting the scope of risk analysis to that of single capital investment projects, as if they were stand-alone projects, has seriously biased the assessment of risk when dealing with project portfolios. The origin of such a slanted approach may be traced back to early authors (Hertz, 1964;Hillier, 1963;Wagle, 1967), who introduced probabilistic modeling in capital budgeting and focused on the technical aspects of single projects. However, capital investment projects are not stand-alone undertakings as they are usually part of a portfolio of projects that makes up the firm. Assessing the riskiness of a single project is a necessary first step that must be carried further. Naturally, the project manager will most certainly be concerned by the single project's specific risk given that it is the only type of risk that he or she can manage and that will impact on his or her personal performance. Carrying out the assessment of risk along the project manager's standpoint as a stand-alone project, however, might lead to suboptimal riskaverse or risk-prone decisions; such decisions might be in stark opposition to the top management's standpoint or the shareholders' interests. In reality, top management will be concerned by the project's contribution to the firm's total risk to the extent that it may impact its sales and operating costs, and increase the firm's likelihood of financial distress and probability of bankruptcy (Shapiro & Titman, 1985;Stulz, 1999). 1 Second, since investors can easily diversify the specific risk of a firm simply by buying shares of its main competitors, there would seem to be no net economic advantage whatsoever-and only at considerable costs-for any firm to embark on a business venture aiming to diversify its economic activities in order to reduce its specific risks. This type of reasoning has wrongly led some to argue that risk management through project diversification, per se, is a total waste of time and resources. 2 Of course, such an argument misses the whole point about a new profitable project, on top of potentially contrib...
