Investors hoping to hedge against the risk of future major pandemic impacts may invest in digital streaming platforms i. At the same time, investors may consider simultaneously investing in airlines positively impacted by less shutdowns. In theory, these two unrelated industries may minimize overall portfolio risk.
How many stocks do you need to own to be properly diversified? A study published in the Journal of Risk and Financial Management found there are simply too many variables to consider and "an optimal number of stocks that constitute a well-diversified portfolio does not exist". Corporate Lifecycle Stages Growth vs.
Value Public equities tend to be broken into two categories: growth stocks or value stocks. Growth stocks are stocks in companies that are expected to experience profit or revenue growth greater than the industry average. Value stocks are stocks in companies that appear to be trading at a discount based on the current fundamentals of a company. Growth stocks tend to be more risky as the expected growth of a company may not materialize.
For example, if the Federal Reserve constricts monetary policy, less capital is usually available or it is more expense to borrow money , creating a more difficult scenario for growth companies. However, growth companies may tap into seemingly limitless potential and exceed expectations, generating even greater returns than previously expected.
On the other hand, value stocks tend to be more established, stable companies. While these companies may have already experienced most of their potential, they usually carry less risk. By diversifying into both, an investor would capitalize in the future potential of some companies while also recognizing the existing benefits of others. Market Capitalizations Large vs.
Small Investors may want to consider investing across different securities based on the underlying market capitalization of the asset or company. Consider the vast operational differences between Apple and Embecta Corporation. Each of the two companies will have considerably different approach in raising capital, introducing new products to the market, brand recognition, and growth potential.
Broadly speaking, lower cap stocks have more room to grow, though higher cap stocks tend to be safer investments. Risk Profiles Across almost every asset class, investors can choose the underlying risk profile of the security.
For example, consider fixed-income securities. An investor can choose to buy bonds from the top-rated governments in the world or to buy bonds from nearly defunct private companies that are raising emergency funds. There are considerable differences between several year bonds based on the issuer, their credit rating, their future operational outlook, and their existing level of debt.
The same can be said for other types of investments. Real estate development projects with more risk may carry greater upside than established, operating properties. Meanwhile, cryptocurrencies with longer histories and greater adoption such as Bitcoin carry less risk compared to smaller market cap coins or tokens.
For investors wanting to maximize their returns, diversification may not be the best strategy. Though there is the higher probably of making life-changing money, there is also the highest probability of losing capital due to poor diversification. Maturity Lengths Specific to fixed-income securities such as bonds, different term lengths impact different risk profiles. In general, the longer the maturity , the higher the risk of fluctuations in the bond's prices due to changes in interest rates.
Short-term bonds tend to offer lower interest rates; however, they also tend to be less impacted by uncertainty in future yield curves. Investors more comfortable with risk may consider adding longer term bonds that tend to pay higher degrees of interest. Maturity length is also prevalent in other assets classes.
Consider the difference between short-term lease agreements for residential properties i. Though there is more security in collecting rent revenue by locking into a long-term agreement, investors sacrifice flexibility to increase prices or change tenants. Physical Locations Foreign vs. Domestic Investors can reap further diversification benefits by investing in foreign securities. For example, forces depressing the U. Therefore, holding Japanese stocks gives an investor a small cushion of protection against losses during an American economic downturn.
Alternatively, there may be greater potential upside with associated higher degrees of risk when diversifying across developed and emerging countries. Consider Pakistan's current classification as a frontier market participant recently downgraded from an emerging market participant.
Investor willing to take on higher levels of risk may want to consider the higher growth potential of smaller, yet to be fully established markets such as Pakistan. Tangibility Financial instruments such as stocks and bonds are intangible investments; they can not be physically touched or felt. On the other hand, tangible investments such as land, real estate, farmland, precious metals, or commodities can be touched and have real world applications.
These real assets have different investment profiles as they can consumed, rented, developed on, or treated differently than intangible or digital assets. There are also unique risks specific to tangible assets. Real property can be vandalized, physically stolen, damaged by natural conditions, or become obsolete.
Real assets may also require storage, insurance, or security costs to carry. Though the revenue stream is different than financial instruments, the input costs to protect tangible assets is also different. Diversification Across Platforms Regardless of how an investor considers building their own platform, another aspect of diversification relates to how those assets are held.
Though this not an implication of the investment's risk, it is an additional risk worth considering as it may be diversifiable. In all three of the situations below, the investor has the same asset allocation. Both deposits are under the FDIC insurance limit per bank and are fully insured.
While there are undoubtedly many reasons for this situation, it suggests that the market may be more interested in growth and the productivity of invested capital than in earnings stability per se. In addition, investors have little incentive to bid up the prices of diversified companies since an investor can obtain the benefits of stabilizing an income stream through simple portfolio diversification.
Related diversification is always safer than unrelated diversification. This misconception rests on the notion of corporate executives that they reduce their operating risks when they stick to buying businesses they think they understand. While this presumption often has merit, making related acquisitions does not guarantee results superior to those stemming from unrelated diversification.
A close reading of the Xerox and Singer cases suggests that successful related diversification depends on both the quality of the acquired business and the organizational integration required to achieve the possible benefits of companies exchanging their skills and resources. Such exchange has been called synergy.
Even more important, the perceived relatedness must be real, and the merger must give the partners a competitive advantage. Unless these conditions are met, related diversification cannot be justified as superior or even comparable to unrelated diversification as a means of reducing operating risks or increasing earnings. A strong management team at the acquired company ensures realization of the potential benefits of diversification.
Many companies try to limit their pool of acquisition candidates to well-managed companies. This policy is rarely the necessary condition for gaining the potential benefits of diversification. Usually such improvement requires an exchange of core skills and resources among the partners. The benefits of unrelated diversification are rooted in two conditions: 1 increased efficiency in cash management and in allocation of investment capital and 2 the capability to call on profitable, low-growth businesses to provide the cash flow for high-growth businesses that require significant infusions of cash.
Indeed, if the acquired company is well managed and priced accordingly by the capital market, the acquirer must exploit the potential synergies with the acquiree to make the transaction economically justifiable. The diversified company is uniquely qualified to improve the performance of acquired businesses.
Consider the testimony of Harold S. We can improve operating efficiencies and profits sufficiently to make this valuation worthwhile to both sets of shareholders. To gain the benefits Geneen claimed, a company needs only to allow managers with the requisite skills to implement their desired improvements in the organization. Rarely, it may be argued, does an organization willingly take steps that could alter its traditional administrative and managerial practices. Under these circumstances, change will occur only when forced from the outside, and diversifying companies often represent such a force.
Nevertheless, the benefits achieved are not, strictly speaking, benefits of diversification. This role involves developing diversification objectives and acquisition guidelines that fit a carefully prepared concept of the corporation. A reduction in the variability of the income stream greater than what could be realized from a portfolio investment in the two businesses—that is, reduced systematic risk. This comparison deserves comment. Most benefits derived from reducing unsystematic corporate risk through diversification are, of course, equally available to the individual investor.
Diversified companies can achieve trade-offs between total risk and return that are superior to the trade-offs available to single-business companies. Diversified companies cannot create value for their stockholders merely by diversifying away unsystematic risk. Inasmuch as investors can diversify away unsystematic risk themselves, in efficient capital markets unsystematic risk is irrelevant in the equity valuation process.
A diversifying company can create value for its shareholders only when its risk-return trade-offs include benefits unavailable through simple portfolio diversification. There are seven principal ways in which acquisition-minded companies can obtain returns greater than those obtainable from simple portfolio diversification. The first four are particularly relevant to related diversification, while the last three are more relevant to unrelated diversification.
When the reinforcement of skills and resources critical to the success of a business within the combined company leads to higher profitability, value is created for its shareholders. This reinforcement is the realization of synergy. The acquisition by Heublein, Inc. At the time, Heublein stood out in this respect because the industry was production-and distribution-oriented. Its principal product was the premium-priced Smirnoff vodka, the fourth largest and fastest growing liquor brand in the United States.
By identifying and then exploiting an emerging consumer preference for lighter-bodied, often slightly flavored products, Heublein helped United Vintners launch two new products—Cold Duck a champagne-sparkling burgundy combination and Bali Hai a fruit-flavored wine. By the end of , one year after its acquisition of United Vintners, Heublein had increased sales by over 2. Investments in markets closely related to current fields of operation can reduce long-run average costs.
A reduction in average costs can accrue from scale effects, rationalization of production and other managerial efforts, and technological innovation. This notion has been the basis of many acquisitions made by consumer products companies. In many industries, companies have to achieve a certain size, or critical mass, before they can compete effectively with their competitors. For example, the principal way many small laboratory instrumentation companies hope to offer sustained competition against such entrenched companies as Hewlett-Packard, Tektronix, Beckman Instruments, and Technicon is to attain a size giving them sufficient cash flow to underwrite competitive research and development programs.
One way to reach this size is to make closely related diversifying acquisitions. Diversification into related product markets can enable a company to reduce systematic risks. Many of the possibilities for reducing risk through diversification are implicit in the previous three ways to increase returns because risk and return are closely related measurements.
However, diversifying by acquiring a company in a related product market can enable a company to reduce its technological, production, or marketing risks. If these reduced business risks can be translated into a less variable income stream for the company, value is created. The diversified company can route cash from units operating with a surplus to units operating with a deficit and can thereby reduce the need of individual businesses to purchase working capital funds from outside sources.
Through centralizing cash balances, corporate headquarters can act as the banker for its operating subsidiaries and can thus balance the cyclical working capital requirements of its divisions as the economy progresses through a business cycle or as its divisions experience seasonal fluctuations. This type of working capital management is, of course, an operating benefit completely separate from the recycling of cash on an investment basis. Managers of a diversified company can direct its currently high net cash flow businesses to transfer investment funds to the businesses in which net cash flow is zero or negative but in which management expects positive cash flow to develop.
The aim is to improve the long-run profitability of the corporation. This potential benefit is a by-product of the U. In November , Genstar, Ltd. There Genstar argued that the well-managed, widely diversified company can call on its low-growth businesses to maximize net cash flow and profits in order to enable it to reallocate funds to the high-growth businesses needing investment. By so doing, the company will eventually reap benefits via a higher ROI and the public will benefit via lower costs and, presumably, via lower prices.
Genstar recycled the excess cash flow into its housing and land development, construction, and marine activities. So Genstar was able not only to employ its assets more productively than before but also to reap economic benefits beyond those possible from a comparable securities portfolio. Diversified companies have access to information that is often unavailable to the investment community. This information is the internally generated market data about each industry in which it operates, data that include information about the competitive position and potential of each company in the industry.
With this inside information, diversified enterprises can enjoy a significantly better position in assessing the investment merits of particular projects and entire industries than individual investors can. Through risk pooling, the diversified company can lower its cost of debt and leverage itself more than its nondiversified equivalent.
As the number of businesses in the portfolio of an unrelated diversifier grows and the overall variability of its operating income or cash flow declines, its standing as a credit risk should rise. Since interest, in contrast to dividends, is tax deductible, the government shoulders part of the cost of debt capitalization in a business venture. These benefits become significant, however, only when the enterprise aggressively manages its financial risks by employing a high debt-equity ratio or by operating several very risky, unrelated projects in its portfolio of businesses.
While this type of company can enjoy a lower cost of capital than a less diversified company of comparable size, it can also have a higher cost of equity capital than the other type.
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Diversification: Many Investors Miss an Important Point
