DIVERSIFICATION - REDUCE LEVEL OF RISKS?

Evaluate whether Diversification is an effective way for companies to reduce their overall level of risks

Diversification involves companies moving into new business areas, either in terms of different products, different ways of delivering these products, or different countries. Many large businesses have achieved expansion using this method, often because they feel they have grown as large as they can do within existing markets. 

1. It is often argues that diversification can reduce overall business risk by “smoothing” a company’s performance over time. In a well-diversified company, when one part of the business is under-performing another part is likely to be over-performing, resulting in the positives and negatives largely cancelling each other out and overall profit remaining relatively stable. Large supermarkets, such as Tesco, are a good example of this.

2. Diversification often also brings expansion, and financial risks may be reduced if new economies of scale are available as a result of entering into new markets. 

3. Being involved in so many markets may also improve the company’s image, therefore reducing reputation risk.

However, 

1. Diversification may not reduce risk at all if the new markets entered into by a company have the same pattern of returns as existing markets. In fact, in this case risk exposure is actually going to increase, not decrease. 

2. It can also be argued that moving into new markets, potentially ones where the company lacks a proven track record, will expose the company to a new set of risks which may increase overall business risk.

3. As with all risk management, a reduction in risk is likely to lead to a reduction in return. In choosing to spread its operations over many markets, a company may find that it loses its specialist skills in its core market and becomes average at everything and brilliant at nothing. As a result, returns may be “smooth” but the average profit margin is highly likely to reduce in the process. 

4. Also, as companies increase in size and the variety and complexity of operations increases, the risks of mistakes being made, poor control systems, fraud etc. are all likely to increase unless the company’s risk management systems keep up with the growth and changes.