What is Diversification and Why is It Needed

a month ago

In any industry where capital investment is involved, be it personal investment in securities or a corporate manufacturing scheme with multi-million dollar cash injections, the ultimate goal is always to make a profit. At the same time, it is a completely natural desire to minimize the associated risks and prevent losses.

To solve these problems, various strategies can be applied, one of the most effective among which is diversification. What is hidden under this concept, why it is used and what varieties are — we will deal with all this in the course of this article.

What is Diversification

Diversification concept
Diversification concept

Diversification — is the introduction of diversification into the product range, expansion of sales markets, distribution of the investment portfolio between different assets and other measures designed to reduce risks and increase profitability in various areas of commercial activity. 

The term itself comes from the New Latin word "diversification" ("diversity, change"), which in turn was formed from the Latin words "diversus" and "facere" ("different" + "to do") and literally translates as "to do different". 

The simplest way to describe the principle of diversification is the well-known adage that you shouldn't put "all your eggs in one basket." If you put them together, the risk of losing your entire stock if the basket falls is very high. But if you store eggs in different places, it will be much more difficult to break them all at once.

What is diversification is explained in simple words in the visual video below:

What is diversification in simple terms

Why Diversification is Needed

The main task of diversification is to reduce the risks of capital loss, combined with the preservation of the income generation scheme.

Without this, investing money in any potentially profitable instrument would be no different from playing roulette, that is, the bet would be made only on luck. 

In any industry of investment and economic activity, the skillful application of diversification strategies allows you to create a flexible structure: 

  • Making a profit;
  • Protection against losses and bankruptcy;
  • Preservation of assets during periods of global economic crises.
At the same time, diversification does not mean a complete elimination of the risk of incurring losses, but only a directed decrease in the likelihood of incurring them.

In some sectors, diversification can have an additional positive effect. For example, the use of certain types of diversification strategies in the economy leads to an expansion of the range of goods and services on the market.

Diversification in production allows companies to fight competition and reduce the level of dependence on suppliers and final distributors of products. Well, and the most common example of the positive impact of diversification measures is the ability to form an effective and reliable investment portfolio.

Types of Diversification

What is diversification
What is diversification

The principle of diversification can be applied in almost any type of commercial activity — in production, investment, business, trading of exchange-traded assets, etc. At the same time, it is almost always a question of reducing the risks of obtaining a loss and increasing the efficiency of a particular entity under consideration or, for example, an entire economic industry. 

Depending on the actions taken, the following types of diversification can be distinguished: 

  • Introduction of innovations — creation of backup options for making a profit in case of a decrease in consumer interest in existing types of products or services;
  • Planning — building a production, business or investment management system aimed at creating a sustainable long-term income generation scheme and preparing options for responding to various unforeseen situations;
  • Balancing risks — selection of an assortment of assets with different levels of profitability and risk in order to increase the likelihood of compensation for losses in different situations. 

You can also classify diversification activities according to the strategy used and the scale of the actions taken:

  • Horizontal — expanding the range of products / services in order to level the risks of losing customer interest within the existing consumer structure;
  • Vertical — reducing dependence on certain elements of the existing profit chain, which can significantly affect economic efficiency. For example, the creation of our own units for the supply and sale of products;
  • Concentric (connected) — the introduction of new elements of production or the provision of services that can increase the efficiency and profitability of the existing commercial system;
  • Conglomerate — the creation of diversified divisions in order to cover as many sales markets as possible and, as a consequence, mitigate the impact of loss of profitability in some of them.
  • Naive — the desire to reduce risks by allocating capital without any strategy. For example, investing in random types of assets without examining their potential return.

The listed classifications of diversification strategies are rather arbitrary and in real life can differ significantly depending on the type of activity in question. 

Portfolio Diversification

Portfolio diversification
Portfolio diversification

Portfolio diversification is a type of investment strategy when the portfolio includes different investment assets (securities, stocks, bonds, etc.), which reduces the risk of losing the invested funds.

Since investing funds always implies the presence of risks, the formation of an asset portfolio should be carried out taking into account diversification. In this case, we are talking about the distribution of money between different types of income generating instruments.The most common ones are:

  • Bank deposits are a reliable way to increase available funds, the main disadvantage of which is a small percentage of profitability. Additional diversification can be applied in the form of opening deposits in different banks;
  • Real estate — the purchase of land plots, buildings and premises, which in any situation allow you to preserve assets and even increase them by renting them out. Risks can be additionally leveled by purchasing real estate for various purposes — residential and commercial; 
  • Currencies — buying dollars, euros and other fiat assets of economically developed countries, including with the aim of reducing the risk of devaluation of the national currency;
  • Exchange-traded assets — stocks, bonds, indices, futures and other types of investment instruments, which are distinguished by increased profitability along with the same high risks.

An important point is that for portfolio diversification to be effective, it is not enough to randomly distribute it among the listed categories.

The choice of specific assets should be carried out taking into account the ratio of potential risks and profitability, as well as tracking their reaction to local and general economic events.

Diversification of Investments

Diversification of investments
Diversification of investments

Investment diversification is an investment approach that involves the selection of risk-based instruments within a separate category, most often exchange-traded assets. 

Balanced investments of this type are those in which, along with highly profitable assets such as cryptocurrencies and shares of promising young companies, there are securities of stable developing corporations, government bonds, precious metals and stable currencies like the euro, dollar and British pound.

At the same time, one should not forget that excessive uncontrolled dispersal of capital between a large number of assets can have an effect that is directly opposite to the initial expectations from diversification.

In this case, there is a risk of investing in insufficiently reliable or liquid securities due to the inability to qualitatively analyze all of them.

The same applies to the inability to monitor the reaction of individual assets to news and economic events if there are too many of them in the investment portfolio.

Therefore, it is recommended to distribute funds in the process of investment diversification no more than between 10-15 assets with different levels of risk and potential return.

Ideally, they should belong to mutually unrelated market categories (currencies, indices, commodity futures, ETFs, stocks, etc.) so that there is no correlation between the change in their value due to the reaction to the same events.

Business Diversification

Business diversification
Business diversification

Business diversification is not only the distribution of capital between different "baskets", but also the strengthening of the position of a company or businessman in the market. And this is achieved in different ways.

First, the range of goods and / or services is being expanded. Moreover, it is more effective to cover completely new product categories, which allows you to continue to receive income if the interest of customers in old ones decreases (horizontal diversification).

Consideration may also be given to the addition of related products / services to increase consumer awareness of the core business (concentric). For example - the creation of departments in grocery supermarkets with toys, school office supplies and other goods that attract the attention of children. Due to this, a customer with a child will visit such a store more often than a competitor's establishment that has nothing to offer to children.

Another option is the geographic diversification of the business, which consists in opening new offices and branches in different cities and even countries. In this case, the risks of loss of income due to, for example, increased competition in a particular location, are significantly reduced, since the profit obtained in other places will help cover these losses. 

The most difficult type of diversification, which is most often difficult for small and medium-sized businesses, is conglomerate, which consists in creating or buying subsidiaries that operate in unrelated directions. In this case, the decline in profitability in one division will be offset by the income of others.

A rather vivid example is Alphabet Inc., which, in addition to owning the most famous search engine Google, has absorbed more than a hundred diverse companies — video hosting sites, gadget manufacturers, software developers, advertising services, cloud platforms, etc.

Diversification of the Economy

Diversification of the economy
Diversification of the economy

Diversification of the economy is an economic model in which a country receives income from different areas of business, i.e. different sectors of the economy must be evenly developed. 

When it comes to the economy of an entire state, diversification is the same prerequisite for stable development and prosperity, as in the case of a separate business. 

This is especially true for countries obsessed with one or more types of industrial activity. For example, in Russia, the economy is mainly based on the oil and energy sectors. Therefore, they receive the most funding.

At the same time, for example, the service sector and agriculture are among the least priority areas. Now imagine what will happen if oil and gas production suddenly ceases to generate income? Will the Russian Federation be able to find the necessary resources in other industries that have been developing very weakly all this time or did not develop at all? It is obvious that if this situation occurs at the moment, the consequences for the Russian economy will be catastrophic.

To eliminate the risks of such scenarios and build a steadily growing economy, the state must apply diversification strategies and engage in the development of many industries, including those that may become useful in the future. 

In addition, it is necessary to provide support to small and medium-sized businesses, as well as to increase trade in international markets, including by increasing the range of products. 

Diversification of Production

Diversification of production
Diversification of production

Production diversification is the reallocation of financing between several production lines in order to reduce the risk of losses. 

Typically, diversification of production consists in applying one or more of the following strategies:

  • Expansion of production facilities for the production of additional types of products in order to cover a larger number of sales markets. This allows you to avoid bankruptcy if the main production ceases to be profitable; 
  • Replacement of outdated technological lines with more advanced ones, including those aimed at the production of new types of products. This allows you to increase profitability in the most unprofitable areas and remove the load from more profitable ones. Often combined with a previous diversification strategy; 
  • Absorption of participants in the production chain (or the creation of their own similar divisions) in order to reduce the company's dependence on third-party factors. For example, the purchase of a supplier company in the long term allows you to reduce the cost of purchasing materials required for production. The risks of stopping production lines due to late deliveries or unexpected termination of cooperation with the supplier of raw materials are also eliminated.
Applying the listed types of diversification, one can achieve not only a steady increase in production efficiency, but also ensure its survival even in times of global economic crises.

Diversification of Risks

Diversification of risks
Diversification of risks

Risk diversification is the distribution of investment funds among various groups of assets such as stocks, bonds, cryptocurrencies, real estate, etc. 

In all of the above types of diversification, risks are central. At the same time, the main task is to minimize their impact on the financial condition of an investor, an enterprise or an entire economic industry. 

Diversification of risks can consist in both balancing them and eliminating the varieties present. By the way, they can be classified according to several criteria:

  • Macroeconomic — associated with the state of the economy of states or global crises; 
  • State — arise as a result of changes in legislation and political force majeure, for example, a forceful change of government. Some of the most dangerous because they are difficult to predict;
  • Sectoral — affect entire layers of the economy, for example, due to the loss of demand for certain categories of goods;
  • Specific — all risks that are directly related to a particular business or production entity. That is, we are talking about such things as a decrease in competitiveness, a loss of a sales market for goods, a delay in the delivery of materials and other situations that can provoke a drop in profitability.

When it comes to business or production, these types of risks are almost always present simultaneously, and their diversification is carried out by a set of measures described in the relevant sections of the article above.

The types of investment risks can be classified in a similar way, but at the same time they will have an indirect relationship to the investor, since they do not relate to him personally, but to those companies that issued securities, or sectors of the economy that affect the rates of a certain type of exchange-traded assets. The diversification of such risks is carried out according to the already mentioned principle of forming a portfolio of different types of securities, currencies, indices and other investment instruments of different levels of profitability. 

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