Diversification: Good or Bad

Definitions

Diversification is a term used in multiple business activities that refers to “the act of introducing variety, especially in investments or in the variety of goods and services offered” or “a growth strategy in which an organisation takes on new products and new markets at the same time”.

As the definitions suggest, the term diversification is applicable in various business environments and/or activities such as financial investments, marketing strategies, and so forth. However, as stressed in the second definition, people tend to associate diversification with growth or risk minimization, but is that totally truth?

Diversification in finance

Within the finance environment, it is common to relate the term diversification with risk minimization, which is translated into lower but more stable returns. The CAPM portfolio model helps to explain how diversification may represent, under certain conditions and certain investment proportions, a risk reduction in a portfolio investment. Nevertheless, it is important to stress that a lesser risk means lower return, so the finance concept of diversification is strictly related to risk minimization and not necessarily to higher rates of return.

Diversification in business

There is a big controversy around the benefits or harm of diversification as a business strategy to achieve corporate growth.

As oppose to the finance environment, the use of diversification in the business environment is less clear and more prone to discrepancies among those who defend it or reject it. The reason for this is in my opinion, that literature tends to create confusion among the readers when referring to diversification in a marketing use of the term as if it was linked to the financial use of the term.

The business use of diversification implies that a business will introduce a new product in a new market, hence amplifying its scope and exploring new markets and strategies to achieve corporate growth. There are several reasons why firms decide to diversify, and most of them are consistent with profit maximization (Montgomery, C. 1994).

Is diversification (in business) an effective way to reduce risk as it is in the finance environment?

Some people may believe that the answer to the question is positive and some other may agree that it is negative.

Specialized firms focusing in their core capabilities are likely to grow up to a point where the mature phase is reached. It is then when the firm should apply new strategies in order to foster corporate growth, bearing in mind that it is advised that diversification is done within the firm’s core capability boundaries with the purpose of reducing the risks of entering new markets and developing new products. (Ansoff, I, 1957)

Depending on the phase of diversification, levels of risks may vary. In my opinion, diversification is a change that always represents risks, but if such risks are mitigated with a correct and adequate management strategy, they can be translated into benefits and future stability can be assured.

References

• Montgomery, C., 1994. Corporate Diversification. Journal of Economic Perspectives - Volume 8, Number 3, Summer 1994, Pages 163-178: American Economic Association, USA

• Ansoff, I., 1957. Strategies for Diversification. Harvard Business Review, Vol. 35 Issue 5, Sep-Oct 1957, pp.113-124

• WordNet Search 3.0: http://wordnetweb.princeton.edu/perl/webwn?s=diversification, accessed 16-AUG-2009

• Monash University – Faculty of Economics and Business – Marketing Dictionary: http://www.buseco.monash.edu.au/mkt/dictionary/ddd.html, accessed 16-AUG-2009