DIVERSIFIVATION
Definition
A portfolio strategy designed to reduce exposure to risk by combining a variety of investments, such as stocks, bonds, and real estate, which are unlikely to all move in the same direction. The goal of diversification is to reduce the risk in a portfolio. Volatility is limited by the fact that not all asset classes or industries or individual companies move up and down in value at the same time or at the same rate. Diversification reduces both the upside and downside potential and allows for more consistent performance under a wide range of economic conditions.
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Why Diversification?
The two principal objectives of diversification are
1. improving core process execution, and/or
2. enhancing a business unit's structural position.
The fundamental role of diversification is for corporate managers to create value for stockholders in ways stockholders cannot do better for themselves1. The additional value is created through synergetic integration of a new business into the existing one thereby increasing its competitive advantage.
Forms and Means of Diversification
Diversification typically takes one of three forms:
1. Vertical integration - along your value chain
2. Horizontal diversification - moving into new industry
3. Geographical diversification - to open up new markets
Means of achieving diversification include internal development, acquisitions, strategic alliances, and joint ventures. As each route has its own set of issues, benefits, and limitations, various forms and means of diversification can be mixed and matched to create a range of options.
Two Types of Diversification
1. Related
2. Unrelated
THREE FORMS OF DIVERSIFICATION
· Vertical Integration - integrating business along your value chain, both upstream and downstream, so that one efficiently feeds the other
· Horizontal Diversification - moving into more than one industry; the new business usually somehow relates to the existing one, although a few conglomerates instead pursue a strategy of unrelated diversification
Geographical Diversification - moving into new geographical area to overcome limited growth opportunities in the local market and/or to gain global leadership positions
MEANS OF DIVERSIFICATION
Do It Yourself
· Internal R&D projects
· In-company startups - new product/service development inside corporation using the business systems approach to project management
· Spinouts - managing innovative product/service development separately
Do It with Others
· Implementing lifestyle projects through new company formation
· Strategic alliances - joint R&D and implementation
Portfolio diversification
An important way to reduce the risk of investing is to diversify your investments. Diversification is akin to "not putting all your eggs in one basket." For example, if your portfolio only consisted of stocks of technology companies, it would likely face a substantial loss in value if a major event adversely affected the technology industry.
There are different ways to diversify a portfolio whose holdings are concentrated in one industry. You might invest in the stocks of companies belonging to other industry groups. You might allocate your portfolio among different categories of stocks, such as growth, value, or income stocks. You might include bonds and cash investments in your asset-allocation decisions. Potential bond categories include government, agency, municipal, and corporate bonds. You might also diversify by investing in foreign stocks and bonds.
Diversification requires you to invest in securities whose investment returns do not move together. In other words, their investment returns have a low correlation. The correlation coefficient is used to measure the degree to which returns of two securities are related. For example, two stocks whose returns move in lockstep have a coefficient of +1.0. Two stocks whose returns move in exactly the opposite direction have a correlation of -1.0. To effectively diversify, you should aim to find investments that have a low or negative correlation.
As you increase the number of securities in your portfolio, you reach a point where you've likely diversified as much as reasonably possible. Financial planners vary in their views on how many securities you need to have a fully diversified portfolio. Some say it is 10 to 20 securities. Others say it is closer to 30 securities.
In either case, you'll still pay a lot in brokerage commissions to put together such a portfolio. For example, if the average trade costs $30, assembling a 10-stock portfolio would cost $300 in commissions. Surely, a cheaper way must exist to achieve diversification benefits.
Mutual funds offer diversification at a lower cost. You can buy no-load mutual funds from an online broker. Often, you can buy shares of a fund directly from the mutual fund, avoiding a commission altogether.
Mutual funds often require an initial investment of between $1,000 and $2,500. However, they generally allow subsequent investments of as little as $25. The Web site of the Investment Company Institute has a list of mutual funds and their toll-free numbers.
Mutual funds hold hundreds of securities in their portfolios. This provides a diversification advantage that's hard to beat. You do face yearly expenses with mutual funds. Management and marketing fees make up most of the fund's operating expenses, which total about 1.5% of your investment each year.
In spite of yearly fees, owning shares of five or 10 mutual funds with different investment objectives may provide great diversification benefits at a lower cost than building a portfolio of individual stocks and bonds.
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