Corporate diversification, economies of scope, and the risk-return relationship

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Corporate diversification was believed to enhance returns and reduce risk. Empirical research was split between supporting and rejecting speculations about the resulting favorable combination of high returns and low risk. The lack of theory in this regard and the empirical controversy made researchers conclude that the favorable risk-return performance is impossible. This study uses a formal model to develop the missing theory of the risk-return relationship in corporate diversification. The model involves two types of economies of scope, intra-temporal economies from resource sharing and inter-temporal economies from resource redeployment. The model demonstrates that, when both economies are present, firms sustain the negative risk-return relationship and can achieve the favorable combination of high returns and low risk. The model carefully explains mechanisms underlying these results.