What is the concept of diversification?
Diversification is a risk management strategy. It is an approach to reduce risk by investing in different asset classes. Diversification aims to maximise returns by investing in multiple avenues that would each have a different response to a market occurrence. The rationale behind diversification is that a portfolio made of different assets will on an average yield higher returns in the long term. It also lowers the risk of holding single security.
What are the advantages of diversification?
The advantages are minimizing risk, preserving capital and generating good returns. Following are the advantages:
- Lowers risk of loss: Investing across different assets helps in minimizing the risk of loss. In other words, even if one asset doesn’t perform well during a period, the other assets in the portfolio help in reducing the potential loss.
- Preserve Capital: Investors nearing their retirement mostly concentrate on preserving their capital. Therefore, diversification can help in protecting savings.
- Returns: Investments do not always perform as expected. With diversification, one can have multiple sources of income and need not rely on just one.
Is diversification a good strategy?
Yes, diversification is a good risk management strategy. Using it, investors can invest in multiple asset classes that help them spread or reduce the risk in the long term. For example, in a portfolio, if one asset is highly volatile to a market condition, with diversification, the other assets will help in minimizing the risk of loss due to that asset.
What is diversification growth strategy?
A diversification growth strategy is when a business enters a new industry which it currently doesn’t operate in. At the same time, growth through diversification also includes creating a new product for a new market.
There are multiple diversification strategies. They are:
- Horizontal Diversification: When a business acquires or develops new products complementary to the current business.
- Concentric Diversification: When a business adds new products to its line with similar technologies or marketing synergies. However, new products appeal to new customers.
- Conglomerate Diversification: When a business adds new products unrelated to the current line of business.
- Vertical Diversification: When a business adds new products to expand forward or backwards on the product chain.
What is related diversification strategy with example?
Related diversification is a strategy where the business adds new products to its line, similar to the current products it offers. For example, a business owning a movie theatre is opening up a recreational park.
What do you mean by product diversification?
Product diversification is a strategy of expanding the original market of the product. This can be done by making changes to the product in terms of resizing, repackaging, repricing, or introducing more variants of the product. This strategy is used by a business when the sales of the product are declining or stagnating.
What are the disadvantages of diversification?
Following are the disadvantages:
- Quality: It can sometimes lead to a low-quality investment portfolio. Investing across more assets will lead to over-diversification, and as a result, the portfolio performance might fall.
- Below average returns: Over diversification leads to lower returns. In other words, if the portfolio has more low performing assets, then total average returns might fall.
- Bad choice of investments: With a need to diversify, some investors start investing across all the available asset classes without doing proper research. Therefore, though diversification is necessary, not all asset classes suit all investors.
- Portfolio monitoring: Over diversification can have an impact on portfolio monitoring. It might get difficult to track the performance of all the assets.
What is diversification risk?
Diversification risk means spreading investments across different assets to reduce the negative impact of exposure to one asset. Risk diversification can be applied to investments and businesses. It helps in minimizing the risk while generating better returns in the long term.
Does diversification reduce return?
Diversification is done to reduce the risk of investing in a single business or asset. It doesn’t increase or decrease the overall return from a portfolio. However, it helps in achieving portfolio returns that are close to the expected returns.
If done well, acts as a protection to a portfolio. It helps in reducing the risk of exposure to any single asset. While diversification helps in reducing risk, over-diversification can reduce the returns of the portfolio. Hence it is always suggested to diversify a portfolio ideally. Too little or too much might harm a portfolio.
What are the different reasons for diversification?
Following are the reasons why diversification for a business or an individual portfolio is essential.
- Reduces Risk: The main aim of diversification is to reduce the overall risk of a business or portfolio.
- Potential to earn high returns: Diversification helps in achieving portfolio returns that are close to expected returns.