Diversification as a risk compensation in the portfolio

Diversification describes the effect of balancing risks in the portfolio. At the same time, the risk of a portfolio is lower than the sum of the risks of the individual investments. The risks are partly opposing because the values or returns of the individual investments usually do not develop in a perfectly uniform manner. For the purpose of diversification, the (risk-averse) investor will divide the amount to be invested and spread it over several investments. The vernacular says: "Don't put all your eggs in one and the same basket."
Diversification in the portfolio assumes that the components combined in the portfolio do not depend in an identical way on external risk factors and vary with them. External risk factors can be the economy, currency parity with the dollar, raw material prices, inflation or a market index.

For an investor, the advantages of diversification result from risk aversion. A person who is risk-neutral does not benefit from diversification.

On the other hand, diversification is associated with disadvantages: more investment opportunities have to be observed and the distribution of the amount to be invested over several investments often means that the individual participation is so small that hardly any decision-making rights can be exercised.

Those who tend to see the advantages of diversification act like a portfolio financial investor. Portfolios are formed from numerous small exposures, and dissatisfaction is expressed through the sale of the relevant component, but not through the exercise of decision-making rights. Therefore, all commitments should be liquid.

Those who tend to see the disadvantages of diversification mentioned above are behaving like an entrepreneur. This is where the use of capital is concentrated, which is why decision-making rights are exercised by management or by leadership. Therefore, investments can be made that are not very liquid.
Diversification is an old phenomenon.
The Talmud, a summary of the two great literary works of Judaism, recommended diversification more than two millennia ago: According to it, a wealthy person should invest a third in land, a third in businesses and a third should be kept liquid
Applied to today's world, this would mean: invest a third of your assets in real estate, a third in stocks, and a third hold liquid or government bonds that can be sold at any time.

In modern technical jargon, this diversification is called naive, because it does not statistically and quantitatively examine the exact diversification effects associated with these classes of investment instruments, but rather sets the weighting in each case a third without further specialist knowledge.

With classical finance theory, which was developed around 1960 by MARKowITz82 and others, diversification was treated quantitatively. The return for the coming investment period is uncertain. It can be described by a random variable. The investment opportunity is all the more risky, the greater the deviation of the return from its expected value. The measure for this is the spread (standard deviation, square root of the variance). Consequently, in finance theory, risk is identified with the spread of return. MARKOWITZ showed: the diversification in the portfolio is largely determined by the correlation between the returns.

Selbstverständlich können auch Risiken diversifiziert werden, die nicht durch die Renditestreuung beschrieben werden oder sich auf eine Anlage in Aktien beziehen. Beispielsweise sind hier Ausfallrisiken bei Anleihen zu nennen, die Risiken von Portfolios, die aus Optionen gebildet sind, oder die besonderen Risiken bei Venture capital.
A complex question is whether a company should diversify. Instead of investing all of its capital and resources in a single line of business, should the company divide it up across multiple lines of business?

1. The intuitive answer is yes. However, in terms of the work of MILLER and MODIGLIANI, it should be noted that (financial) measures by the management of the company cannot represent an increase in value for the owners or shareholders if the shareholders can take these measures themselves and under the same conditions directly. This is likely to be the case with many forms of diversification.

2. Diversification in the company is therefore relevant and increases in value if it can be realized by the company, but not by the shareholders (single-handedly). For example, a company buys other small Finns in which the shareholders wanted to participate, but they are unable to do so because the company is perhaps too small, shares are not traded, or the information barriers are too large.

3. Diversification should also add value if the company can show more stable income due to the diversification of the business areas and therefore achieves an improvement in its creditworthiness vis-à-vis the lenders.

4. Of course, diversification will add value if synergies occur in the real economy (which often turns out to be a pipe dream), or if cost reductions are possible.

5. Heute wird das Unternehmensportfolio nicht nach dem Gesichtspunkt gebildet, daß die zusammengefaßten Geschäftsbereiche irgendwelche Risiken ausgleichen können. Vielmehr werden die Geschäftsbereiche gewählt, damit das immaterielle Kapital der Unternehmung Human capital, Reputation, Marktkenntnisse am besten gepflegt und gestärkt und genutzt werden kann, wie es die Theorie der Internalisierung der Multinationalen Unternehmung nahelegt.

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