Diversification – A Background
In the wake of the 1960’s efficient-market hypothesis, Harry Markowitz introduced the term “diversification” to the American business world. Since then, diversification has become a watercooler maxim surpassed in usage only by the call to disrupt.
In some ways, diversification is worth of its ubiquity.
At the portfolio level, even the most confident stock pickers recommend putting no more than 10% of a bankroll into any single company, and there are clear advantages to diversifying much more. A stock index beats most equivalent hedge funds because of the index’s lower average volatility (and because of its lower fees).
A retirement account can spread across index funds that follow small cap, mid cap, large cap, growth, value, domestic, international, and various classes of bond. Such a portfolio loses only the unrealistic possibility of instant wealth, and wins because of its lower volatility, lower fees, and also lower exposure to risk—its only exposure is to the market itself.
Despite good arguments in favor of Benjamin Graham investing (value strategy of holding money in cash during growth then buy during a crash) and Warren Buffet groupies (activist shareholding with buy and hold), there is a strong argument for diversification being the best way to invest a retirement account.
The Concept Applied to Businesses
At the corporate level, diversification is more complex. In some ways complexity makes diversification even more important. In some ways complexity makes diversification more dangerous.
Success stories are easy to find. In the industrialist era, Cornelius Vanderbilt started as a steamboat tycoon, but became one of the richest men in the world because he first diversified into railroads and then diversified across the continent. John D. Rockefeller built the Standard Oil empire through diversifying product lines (kerosene, beeswax, gasoline), diversifying the supply chain (production, refineries, pipelines), and then diversifying its distribution around the world.
In modern times, Pepsi made gains against rival Coca-Cola by being the first to diversify away from its namesake cola drink toward salty snacks (Frito-Lay, Doritos, Cheetos), non-cola drinks (Tropicana, Gatorade, Aquafina), and other products. Commodity-selling gasoline stations operate on the famously slim gas margin of 1% to 2%, depending entirely on their diversified sales of convenience store sales for profit. Digital Equipment Corp failed to diversify and suffered for it; after dominating the minicomputer business for almost 30 years, DEC was eventually acquired by the competition after failing to diversify into the workstation and personal computer business.
But for every Pepsi there is an AriZona, whose attempt to diversify from iced tea into nachos and cheese was a waste of money. For every gasoline station there is a commodity retailer like Aldi, who gained worldwide distribution from the cost savings of focusing on core items and excluding all else, the opposite of diversification. For every DEC, there is an RCA, who diversified into a motley of companies (publisher Random House, car rental Hertz, frozen food maker Banquet) at the expense of development on its core product lines, eventually selling to General Electric.
In 1979, Harvard Business Review sampled expansion ventures made by existing businesses. Only 18 of 47–or 38%–had made a profit. That’s certainly higher than the 10% of startups that succeed, but remember that startups have nothing to lose. In modern business, your stake is everything you have. 62% of the sampled businesses damaged their existing bottom lines by diversifying.
Those 62% of companies di-worse-ified.
The word “diworsification” comes from Peter Lynch, who used it to highlight the negatives of diversification in his book “One Up Wall Street.” He argues that simplicity is a more efficient and competitive use of time, energy, and resources. He also argues against the averaging effect of diversifying, which applies to both portfolios and business. If you’ve already got one business that beat the startup average, do you really want to risk it for a business that only stands a 38% chance?
If the diversification could increase profit line by better than its risk, then the answer should be: maybe.
A complete exposition on strategic diversification can (and has) filled many volumes, but look for part two of this series for our thoughts on telling the difference between a good diversification opportunity and a bad one—particularly in a small business environment.
If anything from this article, take away this: view diversification as having the potential to be both your best decision ever and your worst decision ever…just like every other strategic decision you make in your business. Diversification is never an automatic next step.