DIVERSIFICATION

According to Investopedia diversification is a risk management technique that

mixes a wide variety of investments within a portfolio. The rationale behind this
technique contends that a portfolio of different kinds of investments will, on
average, yield higher returns and pose a lower risk than any individual
investment found within the portfolio.
Diversification strives to smooth out unsystematic risk events in a portfolio so
that the positive performance of some investments will neutralize the negative
performance of others. Therefore, the benefits of diversification will hold only if
the securities in the portfolio are not perfectly correlated.
Accordingly there are related and unrelated diversification which is discussed
below:
Related Diversification - A process that takes place when a business expands
its activities into product lines that are similar to those it currently offers. For
example, a manufacturer of computers might begin making calculators as a
form of related diversification of its existing business.

Unrelated Diversification - A term which refers to the manufacture of diverse

products which have no relation to each other. An example of unrelated
diversification in a business could be a toy manufacturer that is also
manufacturing industrial wiring for the construction industry.
RELATED VS. UNRELATED DIVERSIFICATION

1.

Some common presumptions about the risks of related and unrelated

diversification
Related

Unrelated
the knitting)

Companies have common core

skills. (Common ThreadStick to

Core skills can be transferred to

acquired companies.

Transferring core skills does not

really matter if you buy a strong
company with skilled managers in
the top and middle levels who will
stay.

Risk is reduced if you stick to

what you think you know: i.e.,
you can use better judgments.

Professional managers can learn

any business.
Unrelated diversification gives a better
chance of diversifying the risks
associated with the business cycle:
portfolio diversification vs. portfolio
specialization.

2.

Potential benefits/drawbacks of diversification

Related

Increased productivity of corporate

resources through operating
synergies; improved competitive
positioning accruing from increased
size of business; and a reduction in
long-run average costs that can lead
to more of a reduction in the variability
of a company's income stream than
would be available from simple
portfolio diversification alone.

3.

Unrelated
More efficient cash management and
allocations of investment capital, and
growth in profits through crosssubsidization can lead to a larger income
than would be available from simple
portfolio diversification.
Reduction of systematic (market-related)
risk is unlikely since systemic risk affects
all equally.

Enabling conditions of successful diversification

Related

Unrelated

Excess capacity in distribution

systems, production facilities, or
research operations.

Competent management in
acquiring company can
adjust
quickly to doing business in
unrelated industries.

Transferable resources and functional

skills have greatest potential for
creating value.
Excess general management
resources.

Recognition by acquiring
management of the different
requirements for
for success in unrelated industries.
Willingness by acquiring management
to include newly acquired topmanagement executives in company
policy-making decision.