Diversity and the Modern Portfolio Theory
Measuring the impact of diversity in organizational excellence has vexed even its staunchest advocate. We can learn, however, from a method of asset diversification used in investment analysis. The modern portfolio theory, also known in the investment trade as MPT, aims to maximize portfolio return at a given level of risk. As an analytical method, it consists of performance measures, mathematical algorithms, and constructs of human risk-return utility functions. The theory posits that for a portfolio of investment assets, maximum return at a given level of risk can be realized in a diversified portfolio [1]. Asset risk that is measured as the variability of the rate of return serves as a proxy for the probability that any such return falls below zero.
Adapting modern portfolio theory to service organizations requires imaginative management. Measuring the contribution of a human resource to the achievement of an organization's goals elevates that resource to the status of the organization’s financial and real assets. Service organizations rely heavily on their employees, but their annual reports don't include their major assets in their statements of condition and income. From the standpoint of a portfolio of employees, the return on investment is the average of each employee’s yearly accomplishment of their commitment to the organization. Portfolio risk, on the other hand, is the average of each employee's variability in performance.
To use modern portfolio theory (MPT), you must adopt a common holding period for analysis. A year is a good choice as an employee’s performance is commonly evaluated annually. The employee’s valuation at the end of the year minus their valuation at the beginning of the year is their contribution to the organization's goal. The cost of acquiring an employee may be the average total cost from candidate search to onboarding while ending cost may include all outplacement costs. If the value of holding an employee for a year is less than the acquisition cost and termination costs, then the employee is not a good investment.
As with investment assets, you need to calculate the expected risk and return for a human resources portfolio. Predicting the most likely risk and return rely on averaging historical values for these two measures. Conceptually, portfolio risk is the co-variability of an employee's return on investment to those of all other employees. Other research in MPT has shown that you can simplify this calculation by determining the degree of association of the variability of an employee's return to the variability of return of a common index [2].
Human resources management and employees often dislike quantitative approaches to performance evaluation. Confusing performance evaluations may be one of the major factors that makes a workplace dysfunctional. Add to this the complexity of employee diversity, and it is obvious that effort in performance measurement has to be given more administrative attention. Once an organization has confidence in the measurement of employee risk and return, it can use modern portfolio theory to evaluate diversity in the workplace.
By Noel Jagolino, contributor. 2023
Author’s Note: I have used similar formulas to form a diversified portfolio of stocks from S&P 500. Portfolio selection was optimally accomplished with Linear Programming to my desired risk level.
References
Markowitz, Harry. Portfolio Selection. The Journal of Finance. 1952.
Sharpe, William F., Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk. The Journal of Finance 1964.
Upper Midwest Social Services - A Case Study. www.mgmtlaboratory.com. January 2018.
Candidate Screening Criteria and Transferable Skills. www.mgmtlaboratory.com. January 2018.
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