Diversification is a technique that reduces risk by allocating investments among various financial instruments, industries, and other categories. It aims to maximize returns by investing in different areas that would each react differently to the same event.
Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk. Here, we look at why this is true and how to accomplish diversification in your portfolio.
The corporate strategy
Corporate strategy is hierarchically the highest strategic plan of the organization, which defines the corporate overall goals and directions and the way in which will be achieved within strategic management activities. It is a long-term, clearly defined vision of the direction of a company or organization.
While business strategy thinks about individual lines of business, corporate strategy refers to how we compete across lines of business.
There are 4 types of companies, considering the level and quality of the diversification they have:
Low diversification / Single Business: this company's revenue comes from a single business unit.
Google is a good example of a business that has numerous businesses they are entering in to but the vast majority of their revenue, at least right now come from search and from their AdWords advertising strategy. Coca-Cola is another good example of a very large business, but its single dominant business is the cola and beverage business, though they do have some other businesses they hold.
Low diversification / Dominant Business: Contrast that to another low diversification type, but one that is not quite as dominated as a single business as the examples I gave before. This might be someone like Pepsi. Now Pepsi differs in Coke in that they have businesses like Frito-Lay and Quaker Foods as part of their portfolio. So while beverages make up a significant portion of their business, they still have other businesses as well that contribute to their revenues.
High diversification / Related: Those that have what we call related diversification, those are businesses that are operating in multiple businesses, but there’s some shared value chain at the end of the day. Think of Disney here. Disney has multiple lines of business but one could argue that there are some synergy, some relatedness between them. This might be Disney’s theme parks feeding into their movies, their movie characters. The movie characters then being used for merchandise and the like. And there are some inter-relatedness between what might otherwise look like very diverse businesses.
High diversification / Unrelated: This type defers from the previous one due to the difference between the different business units. For example, GE and Virgin and clear examples of this type.
Why companies diversify?
There are 3 main groups of reasons of why companies diversify.
- Financial reasons: Capitalize in opportunities in related, unrelated or markets, reduce volatility, or reduce risk.
- Operational reasons: Exploit economies of scale and scope, transfer/leverage rent-generating assets, improve coordination among business.
- Strategic reasons: Eliminate competition by subsidizing a price war, raise rival's cost, reduce rivalry through mutual forbearance, minimize transaction cost of using markets.