Introduction
Investors often encounter two major types of risks while making the investment decision, Diversifiable and undiversifiable. Undiversifiable commonly referred to as "systematic" or "market risk,” is often associated with all companies ( Franklin II, 2011). According to Sprcic (2013), diversifiable risks also known as “unsystematic risk," is believed to be specific to a firm, economy, country, and industry but can easily be minimized or elimination diversification ( Palich, Cardinal & Miller, 2000). Often, diversification is primarily aimed at maximizing the returns by investing in diverse areas which could react differently to a similar event ( Aggarwal & Samwick, 2003). Despite a common agreement among investment professionals that it might not necessarily guarantee against losses, diversification is one of the most imperative aspects to reach long-range financial goals while at the same time minimizing the risks. The old adage that states that ‘do not put all of your eggs in one basket’ rings true in this case. Arguably, spreading the entire financial resources around could be significantly helpful; when it comes to reducing risks, however spreading the money around in the most intelligent way offers the company larger benefits ( Guo, 2011). While reducing risks could result in potentially lower returns, a well-diversified portfolio has historically offered better risk-adjusted returns within a long period.
Thesis
Diversification is important in the management of business risks because it aims to distribute the exposure within the portfolio to ensure that the company does not lose its entire money in case a given investment performs poorly.
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Analysis
According to Iqbal & Shah, (2012), diversification is basically a technique that helps to minimize possible risks through allocating the investments in numerous asset types (Franklin II, 2011).Such is the case since a loss in one of the investments might correspond to a smaller loss in another investment, thus offsetting some of the negative effects. When an investor diversify, he tries to make sure that the value of some of the business holdings might be down while some might be up, however, in overall the business would be doing fine. Conducting a business comes with many associated risks, and it is essential for a firm to identify and manage them to ensure sustainable growth and profits (Franklin II, 2011). In this case, it follows that diversification plays a fundamental role of smoothing out possible unsystematic risk events within a given portfolio such that the positive performance of certain investments might eventually neutralize the negative performances of others. Thus, the overall benefit of the diversification strategy would only hold if securities within a given portfolio are not perfectly correlated.
Research has established that there is significant benefit of diversification in Financial Securities Portfolio, that primarily result into a reduction of risks with required returns (Franklin II, 2011).Thus, through sector diversification in addition to an accurate control of the financial securities with negative relationship between the financial securities, returns results into a reduction in the unsystematic risk and fulfilling high returns. Studies have further established that international diversification plays an imperative role in terms of reducing the systematic risks in the financial securities portfolio (Manuj & Mentzer, (2008). Based on this, it follows that the systemic risks of the portfolio could be significantly minimized through international diversification which would consequently result into a relative stability in the return of the portfolio. Also, the diversification of the international stock indices could greatly play an important role in terms of reducing risks.
Research has shown that diversification between sectors is evidently more effective compared to the diversification between states. Manuj & Mentzer, (2008) claim that well-diversified firms who actively participate in hedging activities and diversification of its assets can significantly improve the firm´s value by reducing costs of external financing and agency cost of debt among others. This means that an efficient diversification would be achieved through acquiring assets from diverse market categories. Clearly, the prices of stocks or a commodity like gold tend to move in an opposite direction. Thus, spreading the capital in various asset groups is termed as asset allocation. It has further been shown that asset allocation is a vital determinant of the long-term investment returns. Sajid, Shujahat & Mehmood, (2016), focuses on the relationship between corporate diversification and a firm’s performance by integrating the impact of ownership structure and business group-affiliation into the relationship. The ultimate goal of a firm is to create value and diversification is an excellent strategy that a firm can use to allocate its resources to their best use as it enables a firm to exploit market power advantages. Studies have emphasized the importance of the capital asset pricing model in order to diversify away business risk (Franklin II, 2011). Thus, there is an advantage of managing corporate risks through diversification.
Diversification is an excellent way to hedge investments depending on the investors risk tolerance levels. Kim, Kim & Pantzalis, (2001) outlines the relationship between a firm’s degree of diversification and earnings volatility. There are two crucial dimensions of diversification, the industrial and geographic dimension. According to Chang & Thomas, (1989), economists emphasize the importance of diversification by spreading out over a wider array of location, activities, timeframe, events, and products. There are various benefits of a well-diversified firm such as the lower average cost of capital, improved supplier relationships and a more competitive presence in the marketplace among others. It is essential to understand that diversification enables a firm to reduce risk, but it cannot eliminate it as diversification has to be adequately integrated into the business operations, and management has to monitor it on a consistent basis (Scholes, 2000).
Franklin II (2011) posits that there is a positive correlation between the degree of diversification and managerial equity ownership or compensation that are tied to the firm's performance. It is essential to understand that the right incentives play a crucial role in forming a well-diversified firm which is able to manage risk effectively ( Hemrit & Arab, 2012). Studies have shown that the management´s primary motivation to make changes in diversification is not the urge to reduce the exposure to business risk but in response to changes in private benefits.
There exist several tactics on how to diversify as a firm in order to effectively manage business risk and ensure that the firm's value is not negatively impacted. According to Sajid, Hashmi & Mehmood, (2016), c ustomer and supply chain diversification represent two strategies that can enable a firm to mitigate operational risk which is a type of business risk. Diversification can be a helpful strategy to increase interest tax shield, to take advantage of growth opportunities, to improve internal capital market and to reduce agency problems. Guo (2011) gives an insight into the effects of various diversification strategies on the firm´s capital structure and the systematic risk and outlines the motivations behind diversification that are essential to understanding when establishing an effective risk management system ( McCallum, 1997). Firms that have lower productivity and growth prospects are more probable to augment their diversification level in order to seek growth opportunities and generate a huge internal capital market to reduce the firm's underinvestment issues.
Despite the fact that diversification has been proven to be an effective strategy to manage risks it has its own limits in risk management. For instance, a positive impact of diversification entirely depends on the dispersive correlations, which clearly might present under the normal market conditions ( Bettis & Mahajan, 1985). Conversely, during the systemically driven crisis, such a correlation tends to become more concentrated. Studies have shown that an increased level of correlation implies that various assets move in a similar direction often ( Sprcic, 2013). Such a case fundamentally nullifies most of the power that diversification could have. In the times of a crisis, diversification could still offer a greater level of benefit particularly where alternatives are included in a portfolio; however, the potential benefits are significantly reduced. Therefore, an event where diversification is not adequate enough, then it follows that it takes additional effort to complete the risk management puzzle ( Hall Jr & Lee, 1999). It is however imperative to note that no matter how the company diversifies its portfolio, the risks could never be completely eliminated.
Conclusion
Based on the above analysis, it is evident that diversification could help a company to efficiently manage the risks and even lower the volatility of an asset’s price movement. However, diversification of the portfolio does not entirely eliminate the risks. An investor can lower the risks related to individual stocks, however, general market risks affect almost every stock, thus, it is imperative to diversify among various asset classes. The fundamental aim should be to establish a medium between returns and risks which will ultimately ensure that an investor achieves his financial goals. It is important that the company diversify its assets further based on the fact that there are numerous risks that might affect the business. Thus the firm should diversify across the board and among different asset classes. Various assets like stocks and bonds do not react in a similar way to an adverse event. A blend of asset classes would thus lower the company’s portfolio’s sensitivity to market swings. The bonds and equity market often tend to move in an opposite direction, therefore, if the portfolio is diversified, then it would follow that unpleasant movement in one would be offset by the positive outcome in another.
Recommendations
There is a positive relationship between risk and returns as well as the effect of diversification on risk-return performance. Kim, Kim & Pantzalis, (2001) assert that firm´s returns significantly influence the diversification strategy. The company can diversify through changes in a number of businesses in the company, changes in industry-specific risk or even in the degree of relatedness among the set of firms among others which can result to an increase in the company's assets.
The business environment has changed significantly, and diversification can have many layers in addition to the corporate level which reflects the number of products or firms in a firm´s portfolio ( Kim, Kim & Pantzalis, 2001). Due to globalization, it is essential to focus on multinational diversification where a firm incorporates elements of various locations into the business portfolio by operating across national borders. A firm should perceive and utilize diversification from a different perspective depending on the respective cultural, political and economic environment.
An operational risk is a form of business risk, and it refers to an unexpected failure in a firm’s day-to-day operations. Destructive events such as the financial crisis that significantly impacted businesses worldwide showed the danger as well as the negative consequences of firms that mismanaged this type of risk. Understanding the sources and effects of operational risk is an essential part of the research that will strengthen the benefits of implementing diversification as a crucial part of mitigating this risk.
Future Research
The future research area of study should be on the number of stocks that an investor should have when using a diversification strategy to manage business risks. It has been argued that owning more than stock might be better than owning just one, however, there are cases where adding additional stocks to the current portfolio ceases to make a significant difference. There has thus been a debate on the exact number of stocks that an investor should have to minimize the risks while at the same time maintain a higher level of return. Therefore, this forms a good area of study that should be researched.
References
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