What Is Diversification?
Definition: Diversification is defined differently based on the context in which it is used. On the one hand, diversification is a business strategy that companies employ to maximize the profit potential of their operations. On the other hand, diversification is a strategy that investors use to construct a portfolio that lessens their risk exposure. Diversifying an investment portfolio enables investors to offset the losses by some assets by the gains by others. As such, the portfolio becomes less volatile.
The business environment is competitive and it offers many opportunities for growth. Businesses grow by investing in opportunities that present themselves, but these investment opportunities carry risks. Fortunately, businesses have learnt to spread the risk over various assets such that they can avoid over-exposure to one asset. This article explains the concept of diversification.
Diversification Example
When you buy assets like stocks to create a portfolio, the portfolio faces two types of risks. The unsystematic risk is that which is unique to a company hence affecting its stock. This risk arises from management issues or any other issue that is unique to that particular company. Then there is the systematic risk. This is the kind of risk that affects the whole stock market. Hence, systematic risk can be consequential to all stocks in your portfolio. What this means is that diversification can only help to cure volatility in a portfolio that arises from unsystematic risk.
From the operational perspective of an organization, diversification is simply the expansion of the product scope across different sectors of the market. Unlike vertical integration, which enables an organization to consolidate its value chain in the same market, diversification entails an organization entering a completely different market. Some organizations opt to diversify through M&A activities while others simply create new products targeting new markets. This article will dwell more on this description of diversification.
Diversification Strategies
In itself, diversification is a strategy that organizations use to grow. New markets open up new growth opportunities for the organization. In fact, diversification is just one of the four growth strategies that make up the Igor Ansoff Growth Matrix. Through diversification, the organization increases the range of products that it sells, which leads to growth in the volume of sales. Other elements of the growth matrix include product development, market penetration, and market development.
Organizations have different strategies through which they can achieve the diversification objective. One of the strategies is concentric diversification. Organizations that deploy this strategy do not move far from the primary product in terms of innovation. For example, a mobile phone company that develops feature phones can diversify by simply moving to producing smartphones.
The second diversification strategy is horizontal diversification. Literally, this means that the organization adopts enters a new market where it produces products that are far unrelated to the primary products.A good example is Apple and how it diversified from making smartphones to producing smartwatches that facilitate fitness. Particularly, the smartwatches still target iPhone owners.
Third, there is conglomerate diversification. This type of diversification is extreme. This is because the company diversifies into a new industry quite unrelated to the current one. Apple, Inc. provides another instance that illustrates this point well. The company entered the content streaming market with the launch of streaming service called Apple TV+.
Diversification Advantages
Generally, diversification smoothens out the volatility in an organization/individual’s assets. Diversification enables organizations and individuals to weather the difficulties that each asset in their portfolio encounters. Another advantage of diversification is that organizations are able to maximize the productivity of its resources. Additionally, diversification provides a smooth getaway from markets whose profit potentially is declining.
Diversification Disadvantages
Diversification is always a trade-off between hedging against risk and maximizing profits. In a diversified portfolio of different assets, some assets may gain bigger profit margins but are offset by underperforming assets. In addition, diversification is expensive. This is because organizations need to develop new capacities and to hire additional labor with new and relevant skills.