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Diversification

Dividing investment funds among a variety of securities with different risk, reward, and correlation statistics so as to minimize unsystematic risk.

Diversification

In risk management, the act or strategy of adding more investments to one's portfolio to hedge against the investments already in it. Ideally, this reduces the risk inherent in any one investment, and increases the possibility of making a profit, or at least avoiding a loss. This may also reduce the expected return on a portfolio, but it depends on level and type of diversification. There are two main types of diversification. Horizontal diversification involves investing in similar investments. Examples include investing in several technology companies or in different types of bonds. Vertical diversification involves investing in very different securities; for example, one may choose to invest in securities traded in different countries, or in both winter clothing and swimsuit companies. Both types of diversification may be as broad or as narrow as the investor chooses. In general, broader diversification equates to less risk and less return. See also: Markowitz Portfolio Theory.

diversification

The acquisition of a group of assets in which returns on the assets are not directly related over time. An investor seeking diversification for a securities portfolio would purchase securities of firms that are not similarly affected by the same variables. For example, an investor would not want to combine large investment positions in airlines, trucking, and automobile manufacturing because each industry is significantly affected by oil prices and interest rates. Proper investment diversification, requiring a sufficient number of different assets, is intended to reduce the risk inherent in particular securities. Diversification is just as important to companies as it is to investors. See also unsystematic risk.
What types of mutual funds provide the best diversification?

Diversification, the notion of "not putting all your eggs in one basket," is among the most celebrated concepts in finance. Economist Harry Markowitz even got a Nobel Prize for turning your parents' oft-repeated advice into mathematical equations. Diversification both reduces investment risk and increases the odds that you'll earn a decent return over time. A big attraction of mutual funds is that they offer instant diversification. You own a portfolio holding anywhere from hundreds to thousands of stocks or bonds for an initial investment that can be as low as $100. The best way to make sure that your equity mutual fund is well diversified—and not just stuffed with the latest high flyers—is to own a broad-based equity index fund. The same goes for fixed-income securities through a bond index fund that invests in both corporate and government debt. Although the annual management is higher, an alternative is an actively managed balanced fund that owns large and small companies and value and growth stocks as well as fixed-income securities.

Christopher Farrell, Economics Editor, Minnesota Public Radio, heard nationally on Sound Money®

Diversification.

Diversification is an investment strategy in which you spread your investment dollars among different sectors, industries, and securities within a number of asset classes.

A well-diversified stock portfolio, for example, might include small-, medium-, and large-cap domestic stocks, stocks in six or more sectors or industries, and international stocks. The goal is to protect the value of your overall portfolio in case a single security or market sector takes a serious downturn.

Diversification can help insulate your portfolio against market and management risks without significantly reducing the level of return you want. But finding the diversification mix that's right for your portfolio depends on your age, your assets, your tolerance for risk, and your investment goals.

diversification

or

conglomerate integration

the expansion of a firm into a range of different product areas which leads to its operating in a number of markets rather than a single market. Diversification may be ‘concentric’ or ‘pure’, the former involving some carry over of production or marketing functions (for example, two firms which utilize a common technological base – razor blades and garden spades both produced from stainless steel and sold through the same outlets – supermarkets), while in the latter case the products are entirely unrelated (for example cars and cement). Diversification may take the form of ORGANIC (INTERNAL) GROWTH, or firms may choose to expand by EXTERNAL GROWTH, merging with or taking over established firms. Concentric diversification via internal growth often arises as a result of new discoveries and applications made by the firm's RESEARCH AND DEVELOPMENT activities as an extension of its existing technological expertise. For example, many producers of basic chemicals have extended their businesses into areas of chemical derivatives, such as paint and pharmaceuticals. In the case of pure diversification, mergers and takeovers often offer the best prospects of a successful entry into a new area.

The main attraction of diversification as a growth strategy compared with HORIZONTAL INTEGRATION (expansion in the firm's existing markets) and VERTICAL INTEGRATION (expansion into different supply levels, but again within an existing market), is the ability to spread risks and broaden the firm's profit-earning potential. Specifically, a one-market firm is vulnerable not only to erratic, cyclical profit returns resulting from the business cycle, but worse still, its very survival may be threatened by a declining customer base as the firm's product moves into the final stages of the PRODUCT LIFE-CYCLE. Diversification is thus the main way the firm can reduce its exposure to business risk and fluctuating profitability, while reorientating its activities away from mature and declining markets into new areas offering sustained growth and profit opportunities.

Diversification may produce synergy (ie, the 2 + 2 = more than 4 effect). Synergy results from complementary activities or from the carry-over of management capabilities. For example, in the case of a diversified merger, one firm may have a strong production organization, while the other excels in marketing – joining the two renders both firms more effective. Similarly, a high degree of carry-over of management expertise may make it possible to reduce production costs and improve product quality of the combined group.

On the other hand a number of problems can arise with diversification, especially if it is of the pure rather than the concentric variety. Diversification may bring with it a loss of ‘focus’ and ‘identity’ with top management trying to do too much and failing to fully comprehend the operational and strategic needs of the company's individual business divisions. This may well be exacerbated by spreading financial resouces for development too thinly so that some divisions remain underfunded and unable to attain their true potential. Together these factors may produce ‘reverse synergy’ (2 + 2 = 3 rather than 5) resulting in under – performance and a depressed share price. Hence the current vogue for ‘unlocking shareholder value’ through hiving-off or demerging divisions as separate quoted companies. For example, BAT Industries the tobacco company spun-off its financial services division setting up a joint venture company with Zurich the Swiss financial services group, while Hanson the leading UK conglomerate of the 1960s, 1970s and 1980s recently split itself up into four separate companies.

Diversification can produce both pro- and anti-competitive effects and for this reason may attract the attentions of the competition policy authorities. Diversifying firms can redeploy profits earned in other areas of their businesses in order to finance entry into new markets, thereby increasing competition in the entered market; on the other hand, ‘cross subsidization’ may be used in a predatory manner to undercut competitors' prices and drive them out of business. In the UK, conglomerate mergers and takeovers involving assets in excess of £70 million may be referred by the OFFICE OF FAIR TRADING to the COMPETITION COMMISSION for investigation, to determine whether or not they should be allowed to proceed. See BUSINESS STRATEGY, PRODUCT-MARKET MATRIX, STRATEGIC BUSINESS UNIT, INTERNALIZATION, SYNERGY, CORE SKILL, CORE BUSINESS.

diversification

or

conglomerate integration

The process whereby a firm expands by supplying a range of different products and, as such, operates in a number of markets rather than a single market. There may be links between the products, based on complementary research, production or marketing functions (e.g. two products that utilize a common technological base - steel razor blades and garden spades - and that are sold through the same outlets -supermarkets) or the products may be entirely unrelated (for example, cigarettes and banking services).

From the firm's point of view, the main attractions of diversification are:

  1. the ability to spread risks by offering a number of products in different markets such that poor sales or losses in one market can be offset by good sales and profits achieved in other markets, thus facilitating a good average performance by the firm overall. By contrast, a one-product firm is extremely vulnerable to cyclical fluctuations in sales over a business cycle;
  2. (from a longer-term strategic perspective) the ability to reorientate its activities away from mature and declining markets into new areas of higher growth and profit potential. A one-product firm is especially vulnerable to both product and market obsolescence in a world of increasing technical complexity and change as new products are invented and new consumer demands created (see PRODUCT-MARKET MATRIX; BOSTON MATRIX);
  3. increased efficiency and financial performance through synergy effects (see below).

On the other hand, a number of problems can arise with diversification, especially if it is of the pure rather than the concentric variety. Diversification may bring with it a loss of ‘focus’ and ‘identity’, with top management trying to do too much and failing to fully comprehend the operational and strategic needs of the company's individual business divisions. This may well be exacerbated by spreading financial resources for development too thinly, so that some divisions remain underfunded and unable to attain their true potential. Together, these factors may produce ‘reverse synergy’ (2+2 = 3 rather than 5), resulting in underperformance and a depressed share price. Hence the current vogue for ‘unlocking shareholder value’ through hiving off or demerging divisions as separately quoted companies. For example, BAT Industries, the tobacco company, spun off its financial services division, setting up a joint venture company with Zurich, the Swiss financial services group, while Hanson, the leading UK conglomerate of the 1960s, 1970s and 1980s, recently split itself up into four separate companies.

Diversification is especially associated with the expansion of large oligopolistic firms (see OLIGOPOLY), controlled in the main by professional managers rather than the firms’ shareholders (see DIVORCE OF OWNERSHIP FROM CONTROL) who pursue growth and long-run profit maximization objectives rather than the goal of static (short-run) profit maximization as portrayed in the traditional THEORY OF THE FIRM (see MANAGERIAL THEORIES OF THE FIRM).

The growing importance of large diversified firms raises some fundamental issues with regard to resource allocation processes. Specifically, RESOURCE ALLOCATION decisions are determined less by competition in markets and have come to depend more on the planning of activities within firms. Competition for investment funds in the market is replaced by competition for funds between various branches within the company, with retained profits providing the finance and senior head office staff acting as an internal capital market, channelling funds from low-profit to high-profit areas. Managers rather than markets become the main arbiters in the resource allocation process. Yet this can be compatible with a diversified firm having only a small market share in each of its many markets, and so no measurable market power of the conventional kind.

In terms of its wider impact on resource allocation, diversification may, on the one hand, promote greater efficiency and stimulate competition, thereby improving resource allocation, or, on the other hand, by limiting competition, it may lead to a less efficient use of resources.

Diversification may produce synergy (i.e. the 2+2 = 5 effect). Synergy results from complementary activities or from the carry-over of management capabilities. For example, in the case of a diversified merger, one firm may have a strong production organization, while the other excels in marketing - joining the two renders both firms more effective. Similarly, a high degree of carry-over of management expertise may make it possible to reduce production costs and improve product quality of the combined group.

Diversification can serve to increase the degree of competition by facilitating entry into industries where entry barriers are too high for smaller, more specialized firms without the financial resources of the conglomerate, i.e. the alternative profit sources to withstand initial losses in new markets while getting established.

Diversification can, however, produce various anti-competitive effects. For example, diversified firms are in a position to cross-subsidize temporary losses in a particular market with profits earned elsewhere. This allows the diversified firm to practise predatory pricing in the market to drive out competitors or discipline them, so raising prices to monopoly levels in the long run. The same financial power and cross-subsidizing capabilities of the diversified firm can be used to bear the short-run costs of deterring new entrants into one of its markets, thereby raising entry barriers.

Where diversified firms face each other in a number of markets, then they may adopt a less competitive stance, each firm avoiding taking competitive action in markets where it is strong for fear of risking retaliatory action by diversified rivals in other markets where it is weak. Here firms may develop ‘spheres of influence’, adopting live-and-let-live policies by dominating in certain of their markets and recognizing the domination of rivals in other markets. The result of such behaviour is a lack of vigorous competition, with higher prices to the detriment of consumers.

The interdependence of diversified firms as buyers and sellers may also distort competition. Where firm A is both an important supplier to firm B for one product and an important customer of firm B for another product, they may engage in reciprocal dealing, buying from firms that are good customers rather than alternative suppliers. The practice allows diversified firms to increase their market shares and increase obstacles to new entry Thus, diversification may produce, simultaneously, both beneficial or detrimental results. Under the FAIR TRADING ACT 1973, a proposed MERGER (TAKEOVER) between two firms supplying unrelated products involving assets in excess of £70 million can be referred by the OFFICE OF FAIR TRADING to the COMPETITION COMMISSION to determine whether or not it operates against the public interest. See VERTICAL INTEGRATION, HORIZONTAL INTEGRATION, TRANSFER PRICING, COMPETITION POLICY (UK), COMPETITION POLICY (EU).

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