Question

Using industry/company examples, what are some tradeoffs between lower and higher levels of diversification?

Answer 1

To understand the tradeoffs between lower and higher levels of diversification, it is important to understand the right meaning of diversification. In finance, a diversified portfolio is one that invests in diverse assets or securities (i.e. uncorrelated/not related to one another).

Essentially, diversification benefits in a portfolio accrue when 2 assets/securities move in an opposite direction to one another. Thus, if a loss occurs in one asset/security invested, its impact is reduced due to no loss (or a lower loss) on the uncorrelated asset/security.

To answer your question, a Lower level of diversification would accrue when investments are in one specific industry, or a related industry. An example here could be the Auto Industry. If we invest our funds into 2 companies of the Auto industry, such as Ford Motors and General Motors, we shall have low diversification benefits. A positive news for the Auto industry could provide positive returns for the two, however a negative news for the Auto industry is most likely to impact both these companies negatively. (Thus, low levels of diversification)

Investments in a related industry could also lead to low levels of diversification. Continuing with our example of the Auto industry, let's assume that the Oil Industry has gone through a slow down, leading to high prices of Petrol, Diesel, etc. This would in turn negatively impact the Auto industry (as majority of the vehicles run due to Petrol /Diesel), making investments in Oil and Auto industry correlated (thus low levels of diversification).

A High level of diversification would accrue when investments are across diverse/different industries. An example in this aspect could be investing in Verizon Communications (Telecom Industry) and Pfizer Inc. (Pharmaceutical Industry). Both the industries are uncorrelated with each other and the performance/news (positive or negative) pertaining to any one of the industries would not affect the other.

It is important to remember that the inclusion of diversification is always desirable as the risk of a portfolio is relatively reduced.