Diversification (Strategy) Finance – Definition
Diversification is a strategy to minimize the risk by diversifying the investment in various sectors. It is allocating the fund in various ways, including separate financial institutions, diverse industries, and investment type. Ideally, eat of these categories respond differently to the same event, thus when one sector goes down, your money is secure with others. Diversification aims at reducing the non-systematic risk in a portfolio.
A Little More About Diversification
Diversification, of course, cannot guarantee against loss; but, the experts agree that it is an effective strategy to reach the long-term financial aim of reducing risk.
Data shows that maintaining a well-planned, diversified portfolio with a multitude of investment instruments (such as stock and bonds) is the key to optimizing a diversification plan. For example, bonds and stocks generally do not react in the same way to an unfavorable market event. Investing in foreign securities is also a good practice for maximizing the benefits of diversification. Domestic investments do not always react similarly to foreign securities when the US economy faces a crisis.
It is also important to invest across different types of industries, as the same (or similar) industries might react similarly to a particular event. Statistically, your investments need to be as uncorrelated as possible in terms of price and demand.
Diversification is not limited to the investment sector. Other industry actors, such as banks and investment companies, also follow a strategy of diversification to minimize their risks and, in some cases, earn higher returns. Banks spread their asset to a large cross-section of diversified borrowers. It helps them to maintain or increase their earnings without affecting the level of exposure.
Investment companies often enter various markets or industries that are different or unique in their core businesses. This technique minimizes the risk of depending on a single or few sources of income. By entering a new industry, they also ensure to cater to different markets by producing diverse merchandise and avoid cyclical instability.
References for Diversification
Academic Reseach on Financial Diversification
- · Investor diversification and international equity markets, French, K. R., & Poterba, J. M. (1991). National Bureau of Economic Research. This research suggests that even though there are obvious benefits to international diversification, investors around the world still expect the returns of their domestic market to be significantly higher to those from markets in other countries. By modeling investor behavior and using data from the U.S., Japan, and Britain, this phenomenon is shown to be a result of the investor’s choices and not governmental or institutional rules.
- · Tobin’s q, corporate diversification, and firm performance, Lang, L. H., & Stulz, R. M. (1994). Journal of political economy, 102(6), 1248-1280. This paper examines the portfolios of diversified and pure-play firms in the 1980s to show that diversified firms had a lower asset value as compared to replacement value at that time. This study shows that diversification does not necessarily provide a firm with a valuable intangible asset.
- · Diversification strategy and profitability, Rumelt, R. P. (1982). Strategic management journal, 3(4), 359-369. This research uses more recent data to build on prior work showing that there is a connection between diversification and increased profitability. The sources of this positive relationship are examined. Empirical tests are used to verify various predictions recognized within the work.
- · International diversification: Effects on innovation and firm performance in product-diversified firms, Hitt, M. A., Hoskisson, R. E., & Kim, H. (1997). Academy of Management journal, 40(4), 767-798. This study examines a theory which questions the effectiveness of internation diversification. The authors demonstrate the benefits and complexities that are experienced by international firms implementing a diversification strategy. The importance of R&D and product diversification are also scrutinized.
- · Strategies for diversification, Ansoff, H. I. (1957). Harvard business review, 35(5), 113-124. The author uses case studies and statistical analysis to determine how and why various firms arrive at their decisions regarding diversification. These historical studies show that firms generally arrive at their decisions through a multi-step process. These process are analyzed and compared to provide guidance in today’s marketplace.
- · Security prices, risk, and maximal gains from diversification, Lintner, J. (1965). The journal of finance, 20(4), 587-615. This research examines the relationship between the market value of risk and the market value of expected returns on securities. Investor responses are analyzed through a series of simple situations. Implications for stock value and portfolio valuations are examined and empirical benchmarks are provided.
- · Does industrial structure explain the benefits of international diversification?, Heston, S. L., & Rouwenhorst, K. G. (1994). Journal of Financial Economics, 36(1), 3-27. This research looks at the how levels of volatility differ inside a country with a diverse industrial structure versus companies that operate internationally within a single industry. The results indicate that diversification across borders is less volatile that diversification within a country. This research uses country index returns for 12 European countries between 1978 and 1922.
- · International diversification of investment portfolios, Levy, H., & Sarnat, M. (1970). The American Economic Review, 60(4), 668-675. This research suggests that while volatility within one nation’s security market can be expected and predicted, risk can be mitigated by diversifying a portfolio across the markets of multiple countries. The author uses statistical analysis of the rates of return on common stocks from 28 countries during the years of 1951 to 1967 to demonstrate his theories about international diversification.
- · Entropy measure of diversification and corporate growth, Jacquemin, A. P., & Berry, C. H. (1979). The journal of industrial economics, 359-369. This research endeavors to empirically find out which methods of measuring corporate diversification perform with the highest level of accuracy. This paper outlines the strengths and weaknesses of the various approaches and identifies a major advantage when using the entropy approach in the analysis of corporate diversification.
- · The link between resources and type of diversification: Theory and evidence, Chatterjee, S., & Wernerfelt, B. (1991). Strategic management journal, 12(1), 33-48. This paper examines the idea that firms diversify in order to make use of extra resources that would otherwise go unused in their operation. Through an application of theory and empirical analysis, the authors are able to predict how a firm with these sorts of surpluses may grow. Through their analysis, they make recommendations about diversification in a variety of situations.
- · Explaining the diversification discount, Campa, J. M., & Kedia, S. (2002). The journal of finance, 57(4), 1731-1762. While it has been documented that diversified firms see a discount on their value, the authors of this study argue that this is not evidence that diversification destroys that firm’s value. By using three different techniques of economic analysis, they assert that this discount is often a result of endogeneity, a statiscal event where the discount is actually correlated with the accuracy of the analysis.
- · Agency problems, equity ownership, and corporate diversification, Denis, D. J., Denis, D. K., & Sarin, A. (1997). The Journal of Finance, 52(1), 135-160. This paper uses historical evidence to assert the idea that a firm’s ability to manage itself and its business is inversely related to its level of diversification. A firm’s diversification can be traced back to forces such as corporate control threats, financial instability, and management turnover.