Diversification Definition Business
Diversification is a strategy undertaken by individuals or businesses that want to minimise risk when investing their capital. It can be described as an asset allocation plan that reduces the ‘unsystematic risk’ that occurs when one factor impacts on investments across one business or small group of firms.
Diversification is the process of putting capital into a range of different places rather than just one – avoiding ‘putting all your eggs in one basket’. This way, there is less chance of losing a significant amount of money because well-performing investments compensate for any poorly-performing investments. Conversely, if all the capital were invested in one place and it suffered a loss in value, a lot of money would be lost.
Research has shown that, on average, a diversified portfolio of investments produces higher returns and incurs less risk than one individual investment. More specifically, a portfolio’s efficiency reaches its peak at 25 to 30 different stocks, after which point the benefits of diversification begin to tail off. Therefore, businesses that want to implement diversification as part of a growth strategy should focus on investing their capital into 25-30 different sources in order to maximise revenue potential.
One only needs to look at businesses like Enron to believe the dangers of an undiversified portfolio – the American energy company encouraged its employees to invest all their capital into Enron stock, leaving them with nothing when the business finally collapsed in 2002.
However, the benefit of diversification has been disputed by people like Warren Buffett, an American businessman and philanthropist. Buffett famously stated: “Diversification is protection against ignorance. It makes little sense if you know what you are doing.” Here, Buffett suggests that diversification is a good risk-reduction technique for those who have little knowledge of the investment market. However, for industry experts who have a good knowledge of current trends, it is more beneficial to raise capital by investing in a few well-chosen securities, limiting risk by investing timely and carefully, rather than by passively spreading capital across a wide range of investments. This is exactly how Buffett has cultivated his fortune, so the method clearly works.
Diversification Strategies in Business
There are three ‘traditional’ investment types, or ‘asset classes’: cash (including current and savings accounts and cash ISAs), shares (equity in a company) and bonds (loans). However, recently there has been a move away from these three main investment types to encourage further diversification within the investment market. Other methods of boosting capital include investment in fixed-rate interest securities, property, antiques, art, collectibles and even gold.
An investor can also diversify by investing in new products or services within their own business; for example, a home improvement store could expand to offer a fitting service for customers that purchase fitted furniture. However, this could have the adverse effect of straining existing services or reducing productivity among employees who are forced to multitask.
Investors could further diversify their portfolio by splitting investments between small and large companies within a range of different sectors. Furthermore, those who invest in foreign securities in addition to domestic securities should benefit from an even more diversified portfolio because foreign investments will be less closely correlated to domestic ones – which is the purpose of diversification.
Bonds are considered to be one of the best ways to generate capital. This is because they can be more stable than other methods, such as equity, which is more volatile. According to Forbes, bear markets can cause equity losses to average 30 percent, and severe financial crashes can lose up to 60 percent of the invested value. Bonds can be used to safeguard portfolios against declines in the value of equity investments, particularly in the short-term, but this stability comes at a price and bonds usually offer less return on investments.
However, more money can be made with equity investments if they are taken out over a long period of time. This helps investors weather major market declines until market losses are made up for.
Diversification with Mutual Funds
Mutual funds can make the task of diversifying a portfolio much easier. Mutual funds are managed by businesses that puts money from investors into a range of different securities. They are created with the aim of helping investors profit from well-chosen investments. By putting capital into one mutual fund, investors benefit from an extremely well-diversified portfolio without having to spend time investing in a range of individual securities.
This is a simpler and more cost-effective method of boosting capital, but because it involves the work of a fund manager or team, it normally costs slightly more in the short-term. Also, while a mutual fund represents an effective investment opportunity on its own, investors should make sure that the securities within the mutual fund are not the same as their existing investments, as this would be counterintuitive.
Diversification with ETFs
ETFs are exchange-traded funds. While mutual funds are managed by an expert team, ETFs depend on a specific market index and can be bought and sold like stocks. This is different to mutual funds, which are purchased at the end of each trading day for a calculated price. As a result, ETFs are much cheaper to purchase than mutual funds, and can cost as little as the price of just one share, along with fees or commissions. There are monetary advantages to each system, however. ETFs are also more tax-efficient, but investors do not pay commission on mutual fund transactions.
Most individuals or businesses in possession of capital look for ways to make their money work for them. There is a myriad of options out there, some of which will be more appropriate than others, depending on the situation. Unless an investor with in-depth industry knowledge can be sure that a certain investment will pay off, a diversified portfolio of any form is a wise business move.