Diversification strategies are used to expand firms’ operations by adding markets, products, services, or stages of production to the existing business. The purpose of diversification is to allow the company to enter lines of business that are different from current operations.
What is Diversification Strategy?
Diversification is at its core about reducing the risk of your investment.
Diversification is especially appealing for investors looking to cut down risk. Selection of an investment with little or no diversification may not be the best long-term investment choice. The reason is because if the investment falls hard, you are left with little or no diversification, which is a hard thing to recover from.
If you have $10,000 to invest in a stock, and your research shows that the best investment opportunity is a single stock, you may be better off to invest in a mutual fund. The reason why is because a mutual fund would diversify the risk of your investment.
For a mutual fund as the whole increases in value, so does your investment. Your individual stock may under-perform versus a stock market index even if it does well. This would be a result of the fact that a stock market index is a group of hundreds of stocks versus your single stock.
Diversifying involves spreading your risk among different assets, either by purchasing many different stock or different types of stock, or by investing in alternative investments such as money market securities, bonds, and real estate.
There is another type of diversification, called “Diversification Strategy.” Diversification Strategy is considered the process of generating multiple profit opportunities in a single business.
This is possible by providing products or services to different groups of consumers. For a business to benefit from this strategy, it should have some similarities in product lines. Those similar offerings can be achieved by targeting foreign markets, entering new and disruptive markets, or by positioning the product or service in an existing market.
What is the Purpose of Diversification?
More and more entrepreneurs are looking to use the power of diversification in the hope of creating wealth. The number of business entrepreneurs is growing at an alarming rate. If a business owner only makes a success of his/her company, he/she still stands to earn a high return on investment as well as remaining employed by the company.
On the other hand, if the business owner opens another company, he/she has a better chance of making more than one success in life. Diversification strategy gives you the opportunity to expand your business without putting all your eggs in one basket.
There are three main reasons for doing diversification strategy. First, to increase the company’s market share. Second, to increase profit margin. And third, to spread the risk of the business.
Business owners use diversification strategies in order to increase sales or reduce their overall operating costs. The opening of a new department, location, or product line can help increase company sales because a diversified company would increase the areas into which its product, service, or brand can be sold.
For example, if you own a restaurant and have four tables for customers to sit in, it is understandable that you will have four waiters wait on those same four tables.
You have now limited your waiters to just working four tables and in the process, you have also limited your waiters’ abilities to serve your customers very effectively. In this case, you should consider expanding your restaurant by adding a new area. This would allow you to employ more waiters and service your customers more effectively.
What does it Mean to be “Asset Diversified”?
Diversification of assets refers to the division of financial investments into different categories to guard against risk. Instead of putting all your financial eggs into one basket, you spread your investments around. A highly diversified portfolio of investments makes it more difficult for one single investment to impact the value of your portfolio.
For example, let’s say you own 100 stocks in the same industry. You would expect most of your holdings to follow similar growth patterns. If the industry is poised for growth, then your stock holdings should increase in value at least in line with the market.
On the other hand, if an investment falls unexpectedly, the impact on your overall portfolio will be less severe. Diversification is considered one of the most successful and well-known investment strategies.
Types of Diversification
Security or Stock Diversification
Consideration must be made before investing in multiple stocks. Each investment should be considered individually. A business owner should ensure that his investment thesis for each stock is quantitative. This means that there is a basis for the investment.
A business owner should not simply diversify because he has money to invest. If a person owns a business that makes golf equipment, it is logical for him to invest in golf stock. It would be illogical for him to invest in stocks that are unrelated to his business.
Industry or Business Diversification
Another avenue of diversification is to spread investments across different industries. This means that a company could be diversified simply by spreading its funds over different business types or industries.
For example, you could have 35% invested in industry X, 40% in industry Y, and 25% in industry Z. Industry diversification is usually a safe bet when a person is still in the growth stage of his investment portfolio.
Future or Technology Diversification
Another type of diversification is to spread investments over different future products or technologies. Many novice investors diversify their investments by investing in future rather than current products and services. When viewing a company’s stock, you can get an idea of the future growth direction by looking at the past performance of that company.
If a company stock has been doing well in recent years, and is still on the rise, then it is possible that you are looking at a solid investment. Future Diversification is a more risky type of diversification than current diversification because it is harder to predict the future.
What is the Difference Between Diversification and Market Diversification?
Almost all businesses focus on developing their activity in the domestic market. Some businesses also choose to test their luck and expand their market abroad, but that is a strategy for a different kind of business.
As a general rule, business owners should avoid making any big investments in the international market until they excel in the domestic market. It’s not because of the competition from foreign businesses, but because small businesses are unable to manage all the risk factors involved in an international market.
What is the Difference Between Diversification and Internationalization?
Internationalization refers to the process of expanding the physical presence of a company overseas. International business refers to making and selling products or services in foreign countries.
Diversification refers to the process of investing in companies that are unrelated to the original business. Diversification expands the investment portfolio from its core business. With diversification, you can create a portfolio to encourage growth and profitability and mitigate risk.
Why Does “Diversification” Work Throughout Time?
Simply put, diversification works because it is not wrong. It is a simple and effective investment strategy that can be applied to different types of assets. Diversification reduces the risk of your overall portfolio by spreading out your investment in assets of various kinds.
In an investment perspective, we don’t expect a diversified portfolio to grow in color patterns, but we do expect it to grow in value. Your diversified portfolio will have assets that grow in value and assets that lose value, but the average result of the diversified portfolio is to grow in value over the long run.
Diversification can also help to smooth out the downsides of investing. Say you have an investment that experiences a loss. The immediate reaction of most investors is to sell the investment, because they fear it may continue to fall in value and affect the rest of their holdings.
Diversification helps to reduce this risk because some of your investments will lose value, but you have other investments that will grow in value and offset the losses. When the market is volatile, diversifying your investments will help you reduce losses and move your portfolio back up to the original value of the investment.
Four Popular Types of Asset Diversification
There are several ways that you can diversify your investments by placing money in different assets.
- Asset Diversification through Asset Classes
There are five main asset classes of investment: large-cap stocks, mid-cap stocks, small-cap stocks, cash and alternative investments. You could theoretically invest your entire portfolio in one of these asset classes, but it is more likely that you will invest in one of them.
Large-cap stocks are the stocks of large companies. They are usually large and stable and their prices do not usually fluctuate much. Mid-cap stocks are the stocks of mid-sized companies. They are a good bridge between small and large companies. Small-Cap stocks are the stocks of small companies. They are more risky than large-cap stocks because they are less proven. The main benefit of small-cap is the growth and the risk of small-cap is the fall that the stock may experience. Cash generally refers to investments that remain liquid such as bank savings, CDs, and government bonds. Alternative investments are investments that are considered “riskier” than the other four options.
By investing in a combination of these asset classes, you can diversify your portfolio by investing in some assets that are generally considered safer and some that are riskier. If your portfolio holds cash and large-cap stocks, the stock market will likely have a negative year due to a large-cap company loss or a strange recession. But, your cash will help you preserve a situation as it is and avoid a general negative loss.
Even though large caps are considered safe, a negative large-cap stock year will represent a general market loss. If you invest in large and small companies, the risk level is reduced on the average.
- Asset Diversification Through Asset Types
Diversification through asset types considers two main types of investments: real estate and physical assets. There are many more types of assets, but these are the two you would consider the most when diversifying your portfolio. Diversifying your holdings through asset types is simply investing in assets that are different categories (or sub-categories) of assets.
For example, investing in real estate and office space is a good way to diversify your portfolio. In addition to providing you with different types of property, these assets provide a different time frame. Office space is usually short-term (3-5 years) while residential real estate is usually long-term (5+, 10+ years).
- Asset Diversification Through Time
Another way to diversify your portfolio is by investing in different times.
Long-term investing is a buzzword that has come up as a good way to stay invested. There is a good reason for this, investing for long-term benefits can help diversify your portfolio. This way you mitigate risk by investing in assets that may be safer than short-term investing.
- Asset Diversification by Building a Portfolio
Building your own portfolio is about creating and managing your own diversified portfolio. This is the most difficult way to diversify your portfolio, but it’s also the only way to ensure that you diversify.
If you choose this route, you will ensure that you don’t have any more than 5% in any one stock (or put another way, you won’t be invested in securities that represent over 5% of your portfolio). It is also important that you integrate asset types and time frames with your portfolio.
After you have placed the basic investment in each asset class of the portfolio and you have calculated the percentage of each asset class, you can then allocate your portfolio assets even more. This is where you can add in asset types and time frames to your diversified portfolio.
If a 5% allocation in the international asset class is your default, you can increase it to 10%. If you want a higher allocation of real estate, you can increase your allocation to 15% of the portfolio. This way, you create a portfolio that is extremely diversified and in line with any risk management strategy that you wish to pursue.
This also means that you will be able to reap the benefits of diversification and risk management even if you decide not to add these factors in later.
What if I have a “Leveraged” Portfolio?
When you have a leveraged portfolio, the amount of the investment is multiplied by the loan that you take. The most common loans are margin loans and margin accounts.
A leveraged portfolio has a 30% loan and 70% equity. If you have the same portfolio of equities as mentioned above, the results will be just like the examples. As the equity moves, your leveraged portfolio will increase or decrease by the actual stock value multiplied by the leverage of 3.0.
For example, you have a portfolio that consists of one international stock, two mid-caps, four small-caps and cash. Let’s assume you buy enough stocks to give you a $50,000 portfolio and you borrow $30,000 to buy the foreign stock. Your portfolio looks like this:
- International Stock $15,000
- Mid-Cap Stock $7,000
- Small-Cap Stock $10,000
- Cash $5,000
This becomes a 31% leveraged portfolio. The stock values are the same, and as you would expect, the results are also similar. During a bear market, the value of the portfolio will decrease, but since your borrowings are 3.0, your losses will be multiplied by 3.0. In other words, the loss will be 3 times the stock value. This means you will lose 33% of your value in the diversified portfolio.
During a bull market, the value of your portfolio will increase, but your 3.0 borrowings mean that the increase will be 3 times the stock value. This means you will gain 33% of the value of your stock.
During a bear market, your leveraged portfolio will halve the value of the stock. If you own an efficient portfolio that is 30% loaned, your actual portfolio value will be guaranteed to halve even with a 30% drop in valuations. If you own a poorly diversified portfolio that is 20% loaned, your total portfolio value will halve if the value of your international stock decreases by 25%.
During a bull market, the leveraged portfolio will double the value of the stock.
If you own a 30% leveraged portfolio, the resulting value of the portfolio will double even if the value of the stock increases by 75%. If your portfolio is 20% leveraged, the value of your portfolio will double if your international stock increase by 50%.
How Should You Invest in Your Portfolio?
When you are diversifying your portfolio, you should see diversification as a part of an overall investment philosophy. If you want to achieve the best possible diversification, you should have a clear idea of what you’re investing for. How are you going to use the money that you put into the portfolio? Will you need it right away in the next 4-5 years, or will you be comfortable with waiting 5+ years before you need the money?
Have a plan before you invest. It’s easy to get caught up in what everyone else is doing, and now that everyone is taking out leveraged loans, you may well feel that you should do the same. It’s better to take a little time to understand your own personal risk tolerance and then build a portfolio around it.
What You Should Know About Diversification and Risk Management
A diversified portfolio will help you achieve your goals. It won’t guarantee anything, but it will help to reduce the risks associated with investing in one asset class. This is the best way to remain invested when the stock market drops.
However, if a market downturn is a major cause for concern, it may be a good idea to wait before you invest in a diversified portfolio. During a market downturn, it’s best to aim for a more conservative approach and then transition into a portfolio with asset diversification. This way, you will limit your risk level to a comfortable degree as you see readjustment value for your investments.
You should also have a plan to protect your portfolio from market downturns. You may not always need it, but it’s still a good idea to have one. You can call it your “DD” plan if you really want to be technical, but it’s really just different ways to protect your portfolio from a downswing.
You shouldn’t use your portfolio to gamble. A diversified portfolio will help you to invest properly, but it shouldn’t include any crazy or volatile investment. These investments should be part of a separate portfolio that doesn’t take up a significant part of your overall portfolio.