Definition of Diversification
Diversification is defined as a technique of allocating portfolio resources or capital to a mix of a wide variety of investments. It is a risk management strategy used to diversify a portfolio in an attempt to limit exposure to any single asset or risk.
The rationale and ultimate goal behind this technique is to reduce the volatility of the portfolio by offsetting losses in one asset class with gains in another class.
As they say, “Do no put all your eggs in one basket”. This just means, “Diversify”.
Having eggs in multiple baskets mitigates risk, because if one basket breaks, not all eggs are lost.
Understanding Diversification and Unsystematic Risk
Diversification is primarily used to smooth out or eliminate unsystematic risk.
Unsystematic risk is a firm-specific risk that affects only one company or a small group of companies.
Therefore, when a portfolio is well-diversified, the positive performance of some investments compensates the negative performance of others. This holds true only if the securities in the portfolio are not perfectly correlated –that is, they respond in a different way, often inversely, to market influences.
Based on studies and mathematical models, maintaining a well-diversified portfolio of 25 to 30 securities yields the most cost-effective level of risk reduction. Investing in more securities generates further diversification benefits, although at a significantly smaller rate.
On the other hand, diversification does not usually affect the inherent, or systematic, risk that applies to the financial markets as a whole.
Systematic risk is associated with every company. This type of risk is not specific to a particular company or industry. It affects the market in its entirety.
The strategy for diversification requires balancing various investments that have only a slight positive correlation with each other – or better yet, actual negative correlation. Having low correlation means that the prices of the securities are unlikely to move in the same direction.
A diversified portfolio is one with capital spread across different asset classes. These should include a mix of growth and defensive assets.
Growth and Defensive Assets
Growth assets include investments such as shares or property and generally provide longer term capital gains, but typically have a higher level of risk than defensive assets.
Defensive assets include investments such as cash or fixed interest and generally provide a lower return over the long term, but also generally a lower level of volatility and risk than growth assets.
In other words, a portfolio is diversified through spreading its risk by investing across different asset classes (i.e. cash, fixed assets, etc.), within asset classes (i.e. purchasing shares across different industry sectors) and across different fund managers if investing in managed funds.
Generally, particular investments will perform better than others over a specific period depending on a range of factors such as interest rates, currency markets, current market conditions, etc.
Therefore, an investor should consider the following specifications in diversifying a portfolio:
- Types of investments. Different asset classes, such as cash, stocks, bonds, ETFs, options, etc.
- Risk levels. Investments with dissimilar levels of risk allows the smoothing or gains and losses.
- Industries. Stock of companies operating in different industries tend to show a lower correlation with each other.
- Foreign markets. Investments should not be limited to domestic markets. There is a high probability that financial products traded in foreign market are less correlated with products traded in the domestic market.
Diversification by Asset Class
Fund managers and investors often diversify their investments across asset classes and determine what percentages of the portfolio to allocate to each. Classes can include:
- Stocks. Stocks are shares or equity in a publicly traded company. It represents an ownership of a fraction of a corporation.
- Bonds. Bonds are government and corporate fixed-income debt instruments. It is an instrument of indebtedness of the bond to the holders.
- Real estate. It refers land, buildings, natural resources, agriculture, livestock, and water and mineral deposits.
- Exchange-traded funds (ETFs). ETFs are marketable basket of securities that follow an index, commodity, or sector.
- Commodities. Commodity is a basic good necessary for the production of other products or services.
- Cash and short-term cash-equivalents (CCE). This includes treasury bills, certificate of deposit (CD), money market vehicles, and other short-term, low-risk investments
They will then diversify among investments within the assets classes, such as by selecting stocks from various sectors that tend to have low return correlation, or by choosing stocks with different market capitalizations.
In the case of bonds, investors or fund managers can choose from investment-grade corporate bonds, U.S. Treasuries, state and municipal bonds, high-yield bonds and others.
Advantages of Diversification
The main importance of using this technique is to maximize returns by allocating investments among various financial instruments, industries and other categories. While many investments professionals agree that, although it does not guarantee against loss, it is a key component in achieving long-term financial goals with a minimum risk.
The following are three key advantages of diversification:
- Minimizes overall portfolio risk
- Capital preservation
- Offers higher returns long-term
- Increases exposure/opportunity
- Hedges against market volatility
The benefit of diversification is to mitigate the risk of an unforeseen bad event taking out you entire portfolio. When you put all your capital in a single investment, you risk losing everything if that investment perform poorly.
Disadvantages of Diversification
While there are many benefits to diversification, there may be some drawbacks as well.
If you have multiple holdings and investments, it may appear burdensome to manage a diverse portfolio. Secondly, since not all investment vehicles cost the same, buying and selling may be costly—from transaction fees to brokerage commissions. More fundamentally, since higher risk comes with higher rewards, you may end up limiting what you come out with.
The following are disadvantages of diversification:
- Burdensome and time-consuming to manage
- Incurs additional costs/fees/commissions
- Limits short-term gains
On understanding the advantages and disadvantages of diversification, we’ll see the types of diversification strategies.
Types of Diversification
The following are the four types of diversification and its pros and cons:
It happens when a company adds or develop a new product or service that appeal to the firm’s customer base. For example, a dairy company that offers cheese to its customers, adding a variety of cheese to its product line.
- Helps businesses overcome touch competitive challenges
- Helps companies expand marketing reach
- Creating economies of scale and economies of scope
- Increased scrutiny from regulatory bodies
- Risk of failure
- Too much growth too fast can deplete resources
It takes place when a company goes back to a previous or next stage of its production cycle. It may be a forward integration or backward integration.
Forward integration is when a business find advantages closer to the integration when a company is at the end of the supply chain. For example, an iron mining company seeking to purchase the steel factories.
Backward integration is when the business at the end of the supply chain looks to find growth opportunities upstream. For example, the media behemoth Netflix branching out into creating their own movies.
- Eliminate reliance on suppliers
- Benefits from economies of scale
- Competitive advantage (possibly) of controlling supply chain
- High initial expenditure and operating costs
- Takes focus off core business
- Not guaranteed cultural fit with current team
It happens when an entity introduces new products with an aim to fully utilize the potential of the prevailing technologies and marketing system. For example, a pizza company branching out to sell calzones.
- Taps into and optimizes current infrastructure
- Can increase market share with less investment than other options
- Allows for business synergies
- Can demand skills outside the wheelhouse of current staff
- Too much, too soon can lead to insufficient resources and lack of attention
- Reduce ability to adapt and be flexible to market changes
It is a type of growth strategy where an entity adds or launches new products or services that have no relation to the current products or distribution channels. Adoption of this strategy is viable towards an all-new group of customers.
A popular example of this is Virgin, which started in the music industry, then diversified into transportation, and later into cellular services among other areas.
- Creates a unique, independent revenue stream, if successful
- Can reinvigorate a legacy brand and create new interest
- Can attract new audiences to the brand
- Can dilute the existing brand
- Perceived strength of the brand may not be enough to make the crossover
- Cost of entry can deplete profits for existing product line