Expansion into a segment of an industry or into an entirely new industry
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Product diversification is a strategy employed by a company to increase profitability and achieve higher sales volume from new products. Diversification can occur at the business level or at the corporate level.
Business-level product diversification – Expanding into a new segment of an industry that the company is already operating in.
Corporate-level product diversification – Expanding into a new industry that is beyond the scope of the company’s current business unit.
Diversification is one of the four main growth strategies illustrated by Igor Ansoff’s Product/Market Matrix:
Diversification Strategies
There are three types of diversification techniques:
1. Concentric diversification
Concentric diversification involves adding similar products or services to the existing business. For example, when a computer company that primarily produces desktop computers starts manufacturing laptops, it is pursuing a concentric diversification strategy.
2. Horizontal diversification
Horizontal diversification involves providing new and unrelated products or services to existing consumers. For example, a notebook manufacturer that enters the pen market is pursuing a horizontal diversification strategy.
3. Conglomerate diversification
Conglomerate diversification involves adding new products or services that are significantly unrelated and with no technological or commercial similarities. For example, if a computer company decides to produce notebooks, the company is pursuing a conglomerate diversification strategy.
Of the three types of diversification techniques, conglomerate diversification is the riskiest strategy. Conglomerate diversification requires the company to enter a new market and sell products or services to a new consumer base. A company incurs higher research and development costs and advertising costs. Additionally, the probability of failure is much greater in a conglomerate diversification strategy.
Why Companies Diversify?
In addition to achieving higher profitability, there are several reasons for a company to diversify. For example:
- Diversification mitigates risks in the event of an industry downturn.
- Diversification allows for more variety and options for products and services. If done correctly, diversification provides a tremendous boost to brand image and company profitability.
- Diversification can be used as a defense. By diversifying products or services, a company can protect itself from competing companies.
- In the case of a cash cow in a slow-growing market, diversification allows the company to make use of surplus cash flows.
Risks in Product Diversification
Entering an unknown market puts a significant risk on a company. Therefore, companies should only pursue a diversification strategy when their current market demonstrates slow or stagnant future opportunities for growth.
To measure the riskiness or the chances of success of diversification, there are three tests used:
- The Attractiveness Test – The industries or markets chosen for diversification must be attractive. Porter’s 5 Forces Analysis can be done to determine the attractiveness of an industry.
- The Cost-of-entry Test – The cost of entry must not capitalize on all future profits.
- The Better-off Test – There must be synergy; the new unit must gain a competitive advantage from the corporation or vice-versa.
Before considering diversification, a company must consider the three tests above.
Examples of Successful Diversification
Here are two notable examples of successful diversification:
General Electric
General Electric commonly comes into discussions when talking about successful diversification stories. GE began as an 1892 merger between two electric companies and now operates in several segments: Aviation, energy connections, healthcare, lighting, oil and gas, power, renewable energy, transportation, and more.
Walt Disney
Walt Disney Company successfully diversified from its core animation business to theme parks, cruise lines, resorts, TV broadcasting, live entertainment, and more.
Additional Resources
Thank you for reading this guide to Product Diversification. As you continue your learning journey, these additional CFI resources will be helpful:
FAQs
If individual stocks are to make up the majority (50% or more) of the equity part of your portfolio, then you should plan to own 25 to 30 stocks. At a min- imum, we recommend owning at least 15 stocks to avoid over-concentration in any single stock or sector.
What's the best explanation of diversification? ›
Diversification is the practice of spreading your investments around so that your exposure to any one type of asset is limited. This practice is designed to help reduce the volatility of your portfolio over time.
Why is product diversification good? ›
Product diversification aims to reduce reliance on a single market by entering new sectors, enhancing business resilience against market fluctuations. Advantages include risk reduction, market expansion, increased company valuation, innovation, competitive edge, resource optimization, and international expansion.
How effective is diversification? ›
Diversification lowers your portfolio's risk because different asset classes do well at different times. If one business or sector fails or performs badly, you won't lose all your money. Having a variety of investments with different risks will balance out the overall risk of a portfolio.
What is the 5% rule for diversification? ›
A high-level rule of thumb for avoid high levels of concentration is that a single stock should not make up no more than 5% of the overall portfolio. This is known as the 5% rule of diversification.
What is an example of too much diversification? ›
For example, an investor who owns an S&P 500 index fund -- which holds 500 of the largest U.S. companies -- and an ETF of technology stock focused on the NASDAQ Composite Index has over-diversified their portfolio.
What is the diversification answer key? ›
Diversification is an investment strategy aimed at managing risk by spreading your money across a variety of investments such as stocks, bonds, real estate, and cash alternatives; but diversification does not guarantee a profit or protect against loss.
What is a diversification strategy in simple words? ›
Diversification is a strategy that mixes a wide variety of investments within a portfolio in an attempt to reduce portfolio risk. Diversification is most often done by investing in different asset classes such as stocks, bonds, real estate, or cryptocurrency.
What is diversification in one sentence? ›
[ U ] the process of starting to include more different types or things: Diversification of your investments lowers risk. The policy may also offer improved energy security through diversification of energy sources.
What is the biggest benefit of diversification? ›
Diversification means lowering your risk by spreading money across and within different asset classes, such as stocks, bonds and cash. It's one of the best ways to weather market ups and downs and maintain the potential for growth.
When you diversify your investments, you reduce the amount of risk you're exposed to in order to maximize your returns. Although there are certain risks you can't avoid, such as systematic risks, you can hedge against unsystematic risks like business or financial risks.
What are the pros and cons of product diversification strategy? ›
It can help you increase your revenue, reduce your dependence on a single source of income, and create a competitive advantage. However, diversification also comes with some risks, such as higher costs, complexity, and uncertainty.
How can diversification be successful? ›
By entering into new markets or product lines, you can expand your customer base and generate new revenue streams. This approach can help you grow your business and achieve economies of scale, which can translate into increased profitability over time. Diversification can help you stay ahead of your competitors.
How does diversification help? ›
Diversification can help reduce the risk that you don't meet your future financial goals. Consider spreading your net worth across multiple asset classes that work in different directions. Don't get drawn into the “chasing returns” mentality.
What is the power of diversification? ›
Diversification not only mitigates risk but also has the potential to furnish smoother and more stable long-term performance.
What is the ideal diversification ratio? ›
In other words, if you're 20 years old, put 80% of your assets in stocks; 20% in bonds. (Most 401(k) plans contain both stock and bond offerings; you can also buy these investments through an IRA.)
What is the 75 5 10 diversification rule? ›
Diversified management investment companies have assets that fall within the 75-5-10 rule. A 75-5-10 diversified management investment company will have 75% of its assets in other issuers and cash, no more than 5% of assets in any one company, and no more than 10% ownership of any company's outstanding voting stock.
What is the 5 40 diversification rule? ›
Asset Diversification
of more than 5% cannot in aggregate exceed 40% of the fund's assets. This is known as the “5/10/40” rule. There are certain exceptions for government issued securities and for index tracking funds.
What is the rule of 42 diversification? ›
The so-called Rule of 42 is one example of a philosophy that focuses on a large distribution of holdings, calling for a portfolio to include at least 42 choices while owning only a small amount of most of those choices.
