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What is Vertical Diversification?

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  • Written By: John Lister
  • Edited By: Kristen Osborne
  • Last Modified Date: 08 December 2016
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Vertical diversification is a term that derives from the same concept, but is applied differently in investing and business. In investing, it refers to a strategy of picking different types of financial assets, rather than just different examples of the same type. In business, it refers to one company taking over a supplier or customer rather than a competitor.

In all finance-related activity, diversification means to become involved in a range of different activities or assets, with the goal of reducing exposure to any one particular risk. It is summed up by the saying of not putting all your eggs into one basket. In investing, diversification means avoiding the risk that a particular investment going badly will have serious overall consequences. In business, it covers the risk of being too reliant on one particular element of the market.

Vertical diversification in investing does not refer to the actual assets the investor picks, such as stocks in three different companies; aiming to increase this variety is known as horizontal diversification. Instead, vertical diversification is about the types of assets. The idea is that investing in different classes of assets will spread the overall risk without overly limiting the potential returns.

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There are several different ways of categorizing assets for diversification purposes. One is into debt products, in which the investor effectively loans money to a company or public body in return for interest payments, and equity products in which the investor buys an ownership stake in the company and may be entitled to dividend payments in the future. Another way is to measure the comparative levels of risk and return; some assets, such as junk bonds, offer a great return, but with a high risk of not receiving the payments. Other assets, such as government bonds, offer a low return, but with as close to a 100% guarantee as an investor is likely to get.

Within the business world, vertical diversification refers to the supply chain, in comparison to horizontal diversification, which refers to competitors in the same market. This means vertical diversification usually means buying out either a supplier or a customer. For example, a soda manufacturer could vertically diversify by buying an aluminum manufacturer or a company that installs and maintains vending machines. In both cases, the idea is to reduce costs, increase revenues, or both, in order to capture a greater share of the money paid by the end consumer.

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NathanG
Post 2

@hamjhe32 - That’s probably true in most cases. But in the case of Intel, it may not make practical sense to buy them out in order to remain profitable as a computer manufacturer.

I am more interested in the vertical diversification as it applies to investments. I made a lot of mistakes by “putting my eggs in one basket” at the height of the Internet boom.

So lately I’ve gotten back into the market but I am very, very diversified. My portfolio consists diversified investments like stocks, bonds, gold and silver.

Even among stocks, I have some that are slow growth, some that are conservative stocks and some that are in foreign or emerging markets.

Diversification won’t get you rich in a hurry, but it will give you something to retire on, in my opinion, provided you have patience and aren’t greedy.

hamje32
Post 1

A vertical diversification strategy is a great idea for business in my opinion. I believe that the problem is, however, that this kind of strategy can mainly be implemented by large corporations that have the resources to buy out their supply chain.

The article’s example of the soda company buying an aluminum company is a good illustration – the soda company must have deep pockets to do this. Another example would be a computer company buying out the manufacturer of some or all of the computer components or hardware.

Typically computer companies buy parts from other suppliers, but if they bought the supplier, I can see how that would reduce costs – and certainly reduce competition.

But think about that. How big would you have to be to buy Intel – the people that make the computer chips? I would say, very big, in my opinion.

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