Diversification

What Is Diversification?

Diversification refers to the practice of extending the range of products or investments to limit systematic exposure to one specific asset or product. It is a risk management strategy. 

It reduces the concentration of capital on a single company or product. If an investor or manager monitors only one asset's movement, all their risks and rewards depend on that asset.

When the asset has high growth, the manager and investor benefit from the profits. However, seasonality and other business risks could also affect the asset, potentially resulting in a loss. 

One can avoid the loss by investing in diversified tools (primarily for investors) or diversifying the portfolio by including a variety of assets. A positive return on one asset can offset a negative return on another.

Essentially, diversification means expanding horizons. The leading question about diversification is whether to diversify or not. It requires careful consideration and balancing of the risks and rewards involved. 

Managers can use diversification to include a range of products in their revenue segments. It can be viewed as an opportunity for development rather than a risk management strategy for a business.

Similarly, investors can diversify their investments across asset classes to reduce portfolio risk. A portfolio, by definition, relates to a collection of investments. Investors who invest in diversified tools create a portfolio and must rebalance it when required.

This article will explain diversification from a business and investor perspective. 

Diversification for Businesses

Business diversification refers to including new revenue-generating segments in the product portfolio. It allows a company to tap into new markets and, in turn, improve its market position through growth.

It assists in increasing the customer base and scope of business. It is a highly used growth strategy whereby more prominent companies have grown, and surviving companies have reached newer heights. 

Before forming a strategy, a manager must compute an internal analysis to understand whether the business can sustain an expansion. An internal analysis entails a clear understanding of the strengths and weaknesses of the company. 

By doing so, a manager can understand whether they have the necessary technical and financial feasibility to expand their business. 

A financial feasibility analysis examines not only the current financial situation of the company but also the overall financial requirements for the new product, including any future expenses.

After conducting these two steps, a manager must decide based on the project's riskiness. It is important to remember that diversification is a strategy that reduces risk but does not eliminate it entirely.

It is easier for more prominent companies to expand to a new market as they can sustain losses if a product does not sell. For example, a world-famous magazine, Cosmopolitan, introduced Cosmopolitan yogurt, which was seen as a significant market failure. 

Advancing from a media company to a dairy product did not make sense to many consumers. Furthermore, the yogurt prices were above the average market prices. This caused a further negative sentiment among buyers, and Cosmopolitan had to relinquish the product. 

The example of Cosmopolitan highlights the importance of careful market research, understanding consumer preferences, and aligning diversification efforts with the company's core competencies and brand image.

Business Strategies

There are several strategies that managers can employ to diversify their businesses. 

Two common strategies are: 

1. Product And Market Diversification

A business has diversified revenue segments when they have more product and service lines that require different information systems and capital expenditures. A company can tap into new markets and increase its sales by expanding to new product lines.

As the sales increase, the business could be more profitable. Usually, companies try to expand their product lines after gaining a substantial market share for their existing lines. 

The various strategies that a business could engage in are:

a. Horizontal Diversification

This technique involves adding products similar to the existing lines and should be related to the same industry. 

b. Concentric Diversification

This technique involves expanding the range of products to attract more customers. 

c. Conglomerate Diversification

In this technique, the business adds a product line from a different industry that is not similar to any existing line. 

2. Diversification Through Mergers And Acquisitions

Mergers and acquisitions provide opportunities for businesses to diversify by adding existing product lines or consolidating with other companies.

With the completion of an M&A, the parent company enjoys the benefits created by the subsidiary, which has specialized in its separate product lines. Thus, an M&A aids in increasing the revenue streams without the hassle of research & development, promotion, and other fees. 

Instead of an M&A, a manager can also opt for a joint venture, wherein a strong alliance is created to supply and produce a new product. 

Advantages Of Business Diversification

3M completed the most well-known successful diversification and has been crowned the title of a Dividend King. A company is considered a dividend king when it consistently increases its dividend payouts for 50 consecutive years. 

3M is a conglomerate with industrial, safety and graphics, health care, electricity and energy, and consumer goods business segments. 

In 2017, after diversifying, the overall sales were $32 Billion, a 5.1% growth since 2016. All revenue segments experienced considerable growth. From this, we can comprehend that the benefits of diversification are endless if executed correctly. 

Let us understand the specific advantages of investing in diversification. 

1. More Customers And Demand

When a business enters new markets, the number of customers increases, creating demand through newer opportunities. 

With the new demand, the business can also secure a new income source that can provide them with stability and helps increase the business's profitability and growth. 

2. Economy Of Scope

Especially for horizontal and concentric diversification, the companies can achieve an economy of scope by producing products similar to their existing lines. 

3. Boosting Brand Name

Improving one’s brand name is the topmost criterion for many companies. With diversification, more customers could access the products creating superior brand recognition. 

Moreover, customers prefer to buy the products of companies they know or have heard of. When a trustworthy business expands into a product line for the same industry, customers prefer to buy their product leading to increased brand recognition. 

Disadvantages Of Business Diversification

The disadvantages of diversifying a business are discussed below.

1. High Entry Costs And Barriers

The costs and risks of diversifying into a new industry or producing new products are significant. The company would need substantial disposable capital for such an expansion. 

Furthermore, this move could prove risky since the business does not entirely understand how the new market operates. 

2. Higher Competition

Every existing market and industry has a leader holding a substantial market share. A company must understand the competitor's strength before expanding. For a product to be successful, it must be such that customers will want to purchase it.

Using a strategy for cost leadership and product differentiation could strengthen their market position. However, this requires significant Research & Development (R&D) and technology spending. 

Diversification for Investors

Investors should continuously diversify their capital across investments so they do not become victims of a specific company’s risk. Although diversification is a recommended technique, it is a cumbersome tool. 

Investors must diversify based on their risk tolerance, i.e., the amount of risk an investor is willing to undertake. When an investor diversifies across various financial instruments and industries, they reduce the overall risk that the portfolio will face. 

The portfolio weightage, or the allocated amount for an instrument, varies per the investor's sentiments. Some analysts recommend using a 60/40 technique, wherein 60% is allocated to stocks and 40% to fixed-income securities.

Diversification continues even after investments are quantified and spread across multiple sectors initially. It is a continuous process that requires rebalancing whenever required. The frequency of rebalancing depends on the investor and their risk appetite. 

Two risks - systematic and unsystematic, can influence a portfolio. Systematic or non-diversifiable risk is the risk that will affect the whole market and not just an individual stock. On the other hand, unsystematic or diversifiable risk only shocks a particular stock or industry. 

The systematic risk is not controllable. For example, COVID-19 was unprecedented, with worldwide repercussions affecting every market and every individual's portfolio. It is not usually predictable, which makes it much harder to control. 

Unsystematic risk arises from the company or industry itself.  This risk is diversifiable as it can be predicted and controlled. 

The unsystematic risk that can affect a company is listed below:

• Business risk
• Financial risk
• Default risk
• Liquidity risk 

Investing Strategies

There are multiple strategies that an investor could utilize to construct a well-diversified portfolio. These strategies can be used separately or as a combination. 

1. Asset Class

Various asset classes can be used for investment purposes. They are listed below, along with a description of each. When an investor diversifies their investments across multiple asset classes, they safeguard their portfolio from market risks. 

a. Stocks / Equities

A stock is a part of the company’s capital distributed to the public so they can raise additional funds. An investor who purchases a company share is known as a shareholder. 

b. Bonds

Bonds are debt instruments that corporations, as well as governments, can issue. In a bond contract, an investor lends money to the government or corporation that returns it on a specified date. A bond is steadier than a stock, indicating a fixed income receivable as interest payments. 

c. Cash And Cash Equivalents

These low-risk securities are liquid cash, usually representing bank or deposit accounts. 

d. Commodities

These tangible goods are usually traded to hedge the effects of inflation. Generally traded commodities include metals (gold, silver), energy, livestock, and agriculture. The prices of commodities are set based on supply and demand, which is unique to the commodity market. 

e. ETFs

Exchange Trade Funds (ETFs) are the most diversified tool an investor can utilize as it holds multiple asset classes within themselves. 

2. Industry / Sector 

An investor can alternatively invest in different stocks belonging to diversified industries. The Global Industry Classification Standard (GICS) broadly classifies stocks based on the following market sectors.

• Consumer Discretionary
• Consumer Staples
• Communication Services
• Energy
• Financials
• Healthcare
• Industrials
• Information Technology
• Materials
• Real Estate
• Utilities

An investor can avoid the risk of a particular industry by investing in negatively correlated companies. 

Diversifying across sectors allows investors to take advantage of various economic cycles and market trends. 

3. Market Size (Large/Mid/Small)

An investor could pool their capital based on the company's relative size. Its market capitalization measures this by multiplying the outstanding shares with the current market price. 

A company is ranked based on market capitalization and placed in the following categories:

• Micro-cap: market capitalization < $300 million
• Small-cap: $300 million < market capitalization > $2 billion
• Mid-cap: $2 billion < market capitalization > $10 billion
• Large-cap: $10 billion < market capitalization > $200 billion
• Mega-cap: $200 billion > market capitalization 

Companies included in the micro and small capitalization categories are said to be riskier than the rest. They have much more growth opportunities but own fewer resources than a mid or large-capitalization company. 

4. Growth Or Value 

Investors can diversify their portfolios by investing in growth or value stocks. 

Growth stocks are associated with companies with high growth potential and investing in innovative opportunities, while value stocks are undervalued companies with stable fundamentals. 

Combining growth and value stocks can help diversify risk and capture different investment opportunities.

Advantages Of Diversification In Investing

Investing is a risky strategy; however, it is an excellent way for individuals to earn extra income. All investors are encouraged to diversify to avoid company-specific risks. 

Here are the advantages of diversifying your investments. 

1. Reduced Risk

The primary reason for diversification is to avoid systematic risks. A rise in another can offset the risk of loss from one stock. In this way, investors could benefit from the overall portfolio value. 

For example, if an investor does not employ the diversification strategy and invests all their capital in one stock, their return highly depends on just one company. This is risky as a sudden plunge in the value would create a heavy loss. 

2. Increased Probability For Higher Returns

Diversifying portfolios allows investors to optimize risk-reward ratios. By allocating investments across different asset classes or securities, investors can benefit from potential returns in various market conditions. 

A well-diversified portfolio should have virtually little to no systematic risk. 

By doing so, the investor immunizes their returns during a market downturn, as they would still earn through the interest receivable on bonds. Similarly, during a market upside, the investor would receive a higher return from the stocks and bonds. 

Disadvantages Of Diversification In Investing

Some disadvantages of diversifying are: 

1. Time Consuming

Constructing a well-diversified portfolio requires research and understanding of different asset classes, industries, and investment options. Furthermore, this strategy is difficult for an investor without a financial background and expertise.

Even if an investor chooses a strategy whereby they only invest in stocks of different industries, it still requires concise judgment using historical data before they can finalize the selected stocks. This is time-consuming, especially for individuals looking for a second income. 

2. More Transaction Fees

As more investments are to be bought, the investor would incur more transaction fees than buying only one asset. 

3. Systematic Risk Is Still Present

Although an investor can never anticipate systematic risk, it is still considered a significant risk factor. The most well-diversified portfolio would always be a victim of systematic risk as it affects the whole market.

Researched & Authored by Astrid Dsouza | LinkedIn

Reviewed and edited by Parul Gupta | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Ansoff Matrix
• Backward Integration
• Brownfield Investment
• Exit Strategy
• Product Diversification