Diversification: Opportunities and risks in financial planning

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Diversification: Opportunities and risks in financial planning

Diversification is a term from the financial industry. It offers interesting opportunities for both companies and private investors, but also risks that should not be underestimated. In the following, we would like to take a closer look at the advantages and disadvantages as well as the implementation of diversification.

Diversification as a key strategy in business

Diversification enables the development of new markets, which is conducive to corporate growth. Those who offer a broad repertoire of products and services can potentially maximize corporate profits. In addition, multiple pillars protect if a product or even an entire industry enters a crisis.

Private individuals can also benefit from the principle of diversification by spreading their assets across different asset classes. In this way, the risk of loss is minimized. However, for the strategy to work as desired, there are some Rules of the game to be observed. This applies equally to companies and private individuals.

Definition of diversification: what it means and why it is important

There are two definitions of diversification. In relation to companies, this refers to an expansion of the service program to include new products and markets. These can, but do not necessarily have to, be thematically related to the company.

A further distinction is made between internal and external diversification. Internal diversification includes, for example, the purchase of merchandise, licensing and in-house development. External diversification includes cooperation and acquisition.

But individual professional or private investors can also use diversification for their own benefit. The aim is to improve the distribution of risk in assets by spreading one's assets over as many different financial products as possible. The idea behind it: If the price of one product falls, the loss can be offset by the other financial products.

Types of diversification: horizontal, vertical, lateral and conglomerate diversification

There are three types of diversification:

  1. Horizontal product diversification: A company expands its product range to include products similar to the industry. Example: A pillow dealer now also sells mattresses.
  2. Vertical product diversification: A company expands its range to include products from a upstream or downstream production stage. Example: A bakery sells milk and eggs in addition to baked goods.
  3. Lateral product diversification: A company expands its range to include products that are No connection to the previous product show. Example: A bicycle dealer sells kitchen appliances.

If you're into finance, you may have heard of a conglomerate. This is a diversified company. This means that the company has numerous subsidiaries in different industries that do not compete with each other.

Horizontal diversification

Advantages of diversification: risk reduction and return enhancement

Diversification brings numerous advantages for both companies and private investors. We would like to take a closer look at these below. Let's start with the advantages for companies:

1. security through a second mainstay

Times change. So it can easily happen that a popular product loses popularity over time. If you have built up a second pillar through other products or services, the loss can be kept within limits or even compensated.

2. corporate growth

Many entrepreneurs are discovering the profit opportunity that diversification represents. Those who offer other related products in addition to their main product (horizontal or vertical product diversification) or even devote themselves to additional industries can maximize corporate profits. In corporate language, from the Opening up new markets the speech.

3. use of synergies

Diversification is also popular with many companies because existing resources can be used to open up new markets. This leads to not inconsiderable savings in time and money. In the area of marketing, for example, the already existing corporate image can be used positively.

Diversification: advantages for private investors

Let us now turn to the advantages for private investors. This means that an investor invests in various financial assets at the same time. The assets are distributed, which brings the following advantages:

  1. Return and security are in balance with each other.
  2. If one investment develops negatively, this can be offset by the other investments.
  3. The return can be maximized by combining different asset classes, while keeping the risks constant.

Challenges of diversification: potential disadvantages and risks

Despite all its advantages, diversification is sometimes viewed critically by financial experts. In the following, we would like to take a closer look at the potential disadvantages and risks:

1. image damage

A company can only achieve the desired economic success if it is able to represent the other business areas in a serious manner. This means that the necessary expertise should be available, especially in the case of cooperations outside the industry. If this is not the case, diversification will do more harm than good.

2. losses and risks due to ignorance

When an entrepreneur decides to diversify, it is not always guaranteed, especially in the case of external diversification, that he knows the customers as well as the conditions of the new industry. If the cooperations and acquisitions turn out to be a wrong decision in retrospect, this can mean a loss that should not be underestimated.

The following risks may be relevant for private investors:

  1. Excessive diversification in the portfolio can have a negative impact on returns.
  2. Lack of expertise in investments in different asset classes significantly increases the risk.
  3. Frequent rebalancing of assets results in high transaction and administration costs.

Diversification in different industries

Balanced diversification is when as many different sectors as possible are represented in the portfolio. The meaning behind this can be explained in a straightforward manner: If one sector is doing badly, another can benefit from it. If you invest in several sectors, it is easier to compensate for losses and you benefit from a potentially higher return.

But what could diversification into different industries look like in concrete terms? First of all, you should know that the world economy can be divided into eleven industries according to the Global Industry Classification Standard (GICS):

  • Consumer goods non-cyclical
  • Consumer goods cyclical
  • Communication
  • Provider
  • Real Estate
  • Technology
  • Energy
  • Health
  • Finance
  • Basic materials
  • Industry

The larger your assets, the more diversified your investment plan should be. It is therefore not essential that you invest in all eleven sectors. Benchmarking is the key to deciding how to allocate your assets.

In finance, benchmarking means comparing the current investment performance of industries. A market-relevant index (e.g. a stock index) serves as a benchmark. You will find an illustrative practical example in here.

Diversification in personal financial planning: the asset classes

For private investors, diversification is a worthwhile way to maximize their wealth. Those looking to invest often hear the following advice: "Don't put all your eggs in one basket!" The basket here is emblematic of industries and asset classes. If these go badly, all the "eggs" - i.e. your assets - are gone at once.

We have already discussed in detail that diversification makes sense for private investors. However, do not make the mistake of investing randomly in a wide variety of sectors.

For a promising diversification, it is crucial how the industries you have chosen relate to each other. This is where the aforementioned benchmarking comes into play. Here the following can help you Financial portal help

Furthermore, it is not only important to have a broad diversification within the sectors, but also across the different asset classes. In this respect, a distinction is made between the following options:

  • Money market instruments (e.g. call money or savings book)
  • Shares
  • Bonds
  • Raw materials
  • Real Estate
  • alternative asset classes (e.g. cryptocurrency)

Strategies for successful diversification: What is there to consider?

If a company wants to maximize its profits through diversification, careful planning in advance is essential. Horizontal and vertical diversification have proven to be particularly successful. For this purpose, the company focuses on related products and existing business areas that have potential for expansion.

The first step is to assess internally which products and business areas are specifically involved: Which new products and enhancements appeal to the individual target group? Once this has been determined, the next step is to exploit existing synergies. Acquisitions, cooperations or start-ups are also possible.

Ideally, the company already has helpful contacts, can use its existing resources for production, and already has an appropriate brand image.

Interesting to know: A large-scale Investigation of the University of Augsburg has dealt in detail with the various diversification strategies, their frequency and their chances of success.

Globalization and Diversification: The Role of International Markets

Diversification plays an important role in the context of globalization. Thus, it not only makes sense to diversify into as many different industries as possible, but also internationally. Expanding into international markets can be another way to generate higher profits and keep the risk of loss low.

If the market situation does not develop as desired in this country, this does not necessarily have to be the case internationally as well. In this way, losses can be offset with an even greater probability.


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