Another positive point that brings companies to diversify is that it sometimes can provide economies of scale. For example, two small firms may not be able to afford effective advertising programs which are expensive. But the combination of those two firms may give them a chance to do so and operate at an efficient level. Additionally, these two firms may afford to buy expensive automated heavy equipment which they need. Another reason of diversification is that companies will be able to exchange of skills and resources. This is very useful for many small companies. Skills or resources that can be imported and exported are usually associated with any functional are such as production, R&D, marketing skills, etc. Popular brand names can also be a reason for diversification. For example, Pillsbury bought Green Giant in part because Green Giant name and image would help Pillsbury introduce new food products.
Other than the reasons, we should also consider carefully about the types of risks in diversification. There are two types of risks, they are systematic risk and unsystematic risk. Systematic risk is “the risk which remains even after extensive diversification” (Bodie, Kane & Marcus, 2002). This is a risk that influences a large number of assets. An example is an economic crisis that struck the country. It is virtually impossible to protect investors against this type of risk. This systematic risk is also known as nondiversifyable risk. Whereas, unsystematic risk is sometimes referred to as a "specific risk". “It's risk that affects a very small number of assets. An example is news that affects a specific stock such as a sudden strike by employees.” (Investopedia.com, 2003). This unsystematic risk can be eliminated by diversification. It is also known as diversifiable risk
There are some risks that can be faced by a company during diversification. Some form of diversification can divert attention from main product. This actually damages the original business by diverting attention and resources from it. For example, Quaker Oats embarked on an aggressive acquisition program in the early 1970s, going into toys and theme restaurants. In the process, however, the company allowed its core business areas to deteriorate. Only one major new product was introduces in the U.S. market during 1970-1978, 100% Natural Cereal. The marketing program by measures such as share and shelf facings suffered (Sample case taken from Aaker, 1984). This type of diversification cost is often overlooked.
Another risk is management difficulties. According to Aaker (1984), a firm’s potential difficulties in managing diversification is magnified when an unrelated business is involved. Numerous firms have found they could not manage a diversification. The management team of the acquired firm might leave and are difficult to replace. The new business may be difficult to learn because the management skills and practices may be different from its previous or main business.
Effects of Diversification on Portfolio,
Risk Management & Company Performance
“With the stock markets bouncing up and down every week there needs to be a safety net for investors. Diversification is the answer.” (Investopedia.com, 2003) A group of assets, such as stocks, bonds, and mutuals, that are held by an investor are known as Portfolio. Currently, markets are always moving up and down, this shows that there are a lot of risks associated with each investment we make. The sources of risks include business cycle, inflation, interest rates as well as exchange rates. So, in order to reduce and manage risks in a portfolio, investors tend to hold more than just a single stock or other asset. For example, if our portfolio is only composed of one stock, Honda Corporation, this one stock will be threatened by so many risks. On the other hand, we can use the diversification strategy, in which we will add additional investment in our portfolio, thus reduces portfolio risks with risk management. So here, not only we invest in Honda Corporation, but we also invest half of our funds in Nestle. By this, if anything happens to our Honda stocks, like if the prices fall, we still have stocks in Nestle which will stabilize portfolio return. This is an illustration of how diversification helps us in minimizing the impact of any one security on overall portfolio performance.
However, we can, not only diversify at two stocks, but perhaps we can diversify our funds into many more securities. Henceforth, by diversifying more and picking different investments with different rates of return will ensure that large gains offset losses in other areas, thereby helping us at risk management and also brighten up our portfolio performance. “But, even with a large number of stocks, we cannot avoid risk altogether, since virtually all securities are affected by the common macroeconomic factors. For example, if all stocks are affected by the business cycle, we cannot avoid exposure to business cycle risk no matter many stocks we hold” (Bodie, Kane & Marcus, 2002).
Since diversification affects risks of our portfolio by splitting funds, company performance is also affected. The reason is that once the risks are decreased, the portfolio of the company also gain returns, hence revenues flow smoothly into the company and increasing its assets and securities. This may lead to the betterment of the company performance for both short and long term. On the other hand, if the diversification fails to reduce risks, it may cause the company’s performance to fall because rate of return is not good and might result in losses for the firm.
Conclusion
Diversification of portfolio may not be the best solution for investors. Still, most investment professionals agree that while it does not guarantee against a loss, diversification is the most important component to helping investors reach their long-range financial goals while minimizing risks. Diversification is possibly the greatest way to reduce the risk Achieving the right medium between risk and return might ensure investors that they can achieve financial goals. But, we should keep in mind that no matter how much diversification we do, it can never reduce risk down to zero.
