Diworsification is a term first introduced by Peter Lynch. It describes how companies might invest in different areas to diversify their business, but end up worsening their overall business. Diversification is often regarded as a great way to reduce risk. However, it all boils down to how the process is conducted.
Some businesses benefit from strategic acquisitions. Despite that, some businesses trying to diversify might find themselves worsening their operations.
It is important to understand how a particular acquisition will positively impact the company. It is also important to know how it can be integrated. Both horizontal and vertical integration can have a positive impact.
Before any acquisition is made, it is important to understand what kind of synergies it will create. Some companies are better off investing in their core business than diversifying into unrelated industries.
Diworsification in investments
Although Peter Lynch initially used the term to describe companies and M&A activity over the late 20th century. Diworsification can also occur in an investor's portfolio. One of the most debated aspects of investments has been the difference between diversified and concentrated portfolios. There are advantages and disadvantages to both approaches. Diworsification can happen in a few distinct ways.
Picking worse investments
Either through picking investments that are worse than the ones you already have in your portfolio. This means that oftentimes investors will pick stocks to add to their portfolios with the intention of diversification, but end up with diworsification.
Another common way investors end up with diworsification is by over diversifying. Diversification is important when you conduct investments. However, if you diversify your investments too much, you might end up with diworsification. Peter Lynch, who managed the Fidelity Magellan Fund for a long time, and managed to achieve great returns over the period.
A fun fact is that the Fidelity Magellan Fund as of 1989 held 1,400 different stocks. His approach clearly showed that you can follow a diversification approach, without diworsification ruining your returns. However, if it is not done correctly, too many stocks might spoil your portfolio.
Investors also make the common mistake of diversifying into correlated assets. An example of this is when investors are bullish on a particular industry. If you buy several stocks in that industry, it is not diversification. This is because the price of correlated assets will often move in the same direction. This ends up with an averaging effect on your portfolio. Basically, your risk/return profile worsens. This is the reason why related diversification can also be a form of diworsification.
It is also common for investors to wrongfully size their positions when they are diversifying. This can be extremely detrimental to your returns. You might end up with a great performing asset that is a small position within your overall portfolio.
How to avoid diworsification?
There are a few ways to avoid diworsification either as a business or as an investor. The first thing you have to ask yourself, whether you are a business or an investor building a portfolio, is what are the advantages of making a particular acquisition. To avoid diworsification you need to make sure that every acquisition you are making has a strong reason and investment thesis behind it.
How to avoid diworsification in business?
Businesses should be extremely cautious when they conduct M&A. M&A has costs, and integrating operations are also costly. It is important to understand how the integration will be done, either vertically or horizontally. Another key aspect is synergies. In short, how will the M&A affect the costs and the potential profits of the business?
Businesses need to make sure that the M&A and integration costs are lower than the potential profits. It should also be considered the cost reduction through synergies generated over a period of time.
How to avoid diworsification in investments?
When it comes to your own portfolio, you need to make sure you know the exact reasons why you are adding a new holding. It is also important to understand how this new investment will behave in relation to your existing portfolio. Diversification into assets with positive correlations is basically diworsification. Keep this in mind in order to avoid diworsifying your portfolio.
How to fix diworsification in investments?
The best way to fix diworsification is to sell your position. When you make a mistake make sure you fix it right away. It may be costly, and you may end up losing some money. However, whenever you encounter a mistake it is always wise to fix it as soon as you can. Make sure you learn from it so that you can avoid it in the future.