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Asset Diversification: What Is It All About?

Seasoned investors often say that you shouldn’t put all your eggs in one basket. The phrase is a concise representation of the asset diversification concept. For a diversified portfolio, it’s essential to not be dependent on a single asset. Regrettably, this common error may lead to financial setbacks for inexperienced investors. They might invest all their capital and assets into a single project, anticipating quick profits. Say, a number of investors incurred significant losses a few years ago due to the unpredictable GameStop stock prices. These stocks saw a sudden increase in value, only to experience a steep decline shortly after. To steer clear of such risky scenarios, grasping the principles of effective asset diversification is a sheer necessity. The International Wealth team will eagerly help you with this. Below, International Wealth experts will show you how to stay out of trouble and explain the basics of spreading out your investments for efficient asset diversification. Assisted by our top pros, you’ll invest your money safely. 

Asset Diversification

What is asset diversification?

Basically, asset diversification involves spreading your investments across different types of assets. For example, this is what a diversified asset portfolio might include:

This way, if one asset type drops in value, the increased value of other assets can balance out any losses. Such a strategy lessens the chance of all your investments dropping at the same time, which is a greater risk when all your money is in a single asset.    

Asset diversification is a strategy with several benefits, often used by those not primarily involved in business or investing to protect their earnings: 

  • An electrician working at a factory might also provide services on their own. 
  • A dentist could run a private practice alongside their work at a clinic. 
  • A freelancer typically handles various projects from different clients at the same time.

Asset diversification is both a nuanced and comprehensive process. Should you feel unsure about properly distributing your assets and finances across different investment options, you’d better delegate this responsibility to seasoned experts, like our team at International Wealth, to avoid future regrets over misallocated funds.

Main activities benefiting from diversification strategies

Asset diversification is a key strategy employed in various sectors:

  • manufacturing
  • business
  • investment
  • economy
  • private activities.

Manufacture diversification

Manufacturing business owners aim to broaden their range of products by utilizing the capacities they have. When these are not enough, they invest in additional equipment.

Take the example of a pastry factory that produces cakes, pastries, and ice cream. Not all products sell consistently as some are seasonal, and others aren’t bought every day. To complement its main offerings, the factory might also market essential baking ingredients like cake layers, pre-made cream, and chocolate. Or, it could grow its operations by adding a bakery or dairy section to create and meet the everyday demand on a larger scale.

As a result, the factory would secure an extra source of income and enhance its stability against possible economic downturns. Why? Essentials like bread, butter, and milk will continue to be in demand, even when the general populace experiences a drop in income.

Business diversification

Here, investments in new ventures that do not clash with the core business are meant. Say, a company may obtain a license for a different business line, expand its reach to new regions, set up a subsidiary abroad, and open international bank accounts to tap into global markets.

Investment portfolio diversification

A company or individual investor spreads their investments over various unrelated initiatives. These projects might span multiple countries, which helps disperse the risk associated with economic slumps. A typical mistake among newbie investors is to overestimate a sector’s potential. For instance, they may assume the construction sector is set to expand. In an effort to protect against uncertainties and diversify their holdings, they might buy shares from different construction firms, yet all located in the same jurisdiction.

However, investors’ assumptions may turn out wrong, resulting in a construction sector crisis with a simultaneous drop in all developers’ stock values. If the investments had been spread across various countries, the financial impact would have been less severe. Actually, engaging with international markets, opening foreign accounts, and establishing businesses abroad may be simpler than they seem at first glance.

Economic diversification 

Nations also mitigate risks by allocating funds across different economic sectors instead of just one. They often finance key businesses that are crucial to industry-wide growth, including significant market leaders. Simultaneously, countries support emerging startups, like those in the IT field, recognizing their potential.

Diversification of activities 

With stiff competition in the job market and the rapid progress of neural networks, people are learning new skills and exploring current in-demand careers to get out of the unemployment trap.

For example, sought-after IT professionals are branching out into related areas like social media marketing and design to become more versatile and meet the varied requirements of employers. Similarly, programmers who work with artificial intelligence are also getting into no-code development to maintain their marketability and job security.

Diversification types

Diversification comes in two main forms: related and unrelated. Within related diversification, there are further distinctions:

  • Horizontal Diversification: The strategy is intimately connected to a company’s primary operations. It might mean adding new products that are akin to the existing ones. This method of diversification doesn’t require changing current production processes, though new equipment might be necessary. By expanding its product line, a company can successfully venture into new markets and reduce the risks of depending on a single one.

Thus, BIC initially focused on producing ballpoint pens. Using the same manufacturing equipment, technology, and materials, the company extended its range to offer lighters and razors as well. This expansion allowed BIC to diversify with minimum additional investment.

Similarly, The Walt Disney Company started with an animation studio. Over time, it expanded its offerings to include film production, theme parks with cartoon characters, as well as its own streaming service.

  • Vertical Diversification: This approach involves a company incorporating various phases of product creation into its own operations. Thereby, the enterprise enhances its business scope. For example, a company may evolve from buying products to producing them internally. It starts with acquiring raw materials and shifts to self-manufacturing these materials later. The company keeps all manufacturing processes in-house and sells the final product through its proprietary retail outlets.

This strategy makes a company more independent from outside manufacturers and suppliers. It can manage its growth effectively, making sure raw material providers stick to timelines and distributors achieve sales targets. Excess raw materials may be sold to other businesses that make different products using the same materials. For example, chrome-plated steel is sought after for both furniture production and creating items like faucets, sinks, and more.

Unrelated diversification proves most beneficial when a company enters markets not connected to its main line of business. This often requires significant capital for setting up production from the ground up. Yet, the above strategy can help a business reduce risk by owning stakes in diverse sectors over the long haul. Take a look at the examples below:

  • Johnson & Johnson, a global conglomerate with 250 subsidiaries, produces a range of medical and children’s cosmetic hygiene products, with powders, gels, and lotions among them. Each division operates independently with its own management, production facilities, and machinery.
  • Virgin Group is a vast empire of businesses spread across different industries, including air and rail transport, space tourism, property trading, video game development, and media production.

Risk diversification: pros and cons

While not immediately obvious, methods of minimizing risks do have their drawbacks:

  • Introducing a new product or breaking into a different market requires investment. Companies that practice either related or unrelated diversification may face resource limitations, e.g., a lack of funds, time, expertise, or staff.
  • The danger of losing focus is real. Spreading efforts across various fields may lead to a company neglecting the core competencies that originally made it successful.
  • The complexity of managing a diverse asset portfolio increases. More assets mean extra time spent analyzing each one’s market dynamics. Plus, there’s a higher risk if, say, only 10 out of 50 stocks are profitable, and the rest decrease in value or don’t meet expected returns. Unprofitable assets or ventures may potentially offset the gains from successful ones.

Now, it is high time we take a look at the benefits that diversification may come with:

  • Diversification reduces the likelihood of financial loss by distributing investments across various channels. Thereby, gains in some areas balance out losses in others.
  • Diversification allows investors to concentrate on new, potentially high-reward assets without jeopardizing their entire capital. In the absence of the above opportunity, this would hardly be possible.
  • Diversification enhances the competitiveness of a business. It lets the company explore new niches and complement its core business with new products.
  • Businesses become less vulnerable to the impact of crises. Losses from unprofitable ventures can be compensated for by profitable ones.

Summing up

Diversification is a strategy whereby businesses or investors spread their investments over a range of assets and projects. Its purpose is to reduce the chances of financial setbacks. There exist various approaches to risk diversification across all fields. Thus, firms expand into new areas, closely related to or completely distinct from their main activities, investors spread their investments among different sectors, types of currency (traditional or digital), and nations. However, beware: even a well-thought-out diversification plan can’t offer absolute assurance against the loss of capital.

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