Portfolio diversification and the paramount advantages in the protection of investors from market unpredictability

Diversification has its fair share of rewards and risks which can make or break the company entirely. There are more sourceable examples that diversification benefits a company rather than costing the company. Even with proper calculations and plannings, diversification can be unforeseeable and that contributes extra risk to the company. There will be changes, could even be drastic ones to the already in place corporate strategy, management team, expertise, financial, milestones and many other areas. However, if the corporation is able to adopt and absorb these changes, there will be a long term reward awaiting them especially in this volatile market setting.

Nevertheless, the market is always shifting and there are many replacements. The many factors revolving around human needs and wants causes the market to be unpredictable. With technology and more channels to consumers and customers, new businesses are aiming to be disruptive. Such businesses often eat into a huge chunk of the market share with their innovative products or services, and replace the demand of traditional businesses. In view of Porter’s five forces, there are different ways a company can become obsolete. To make the matter more serious, we are looking at an ordinary economy setting where a business can be replaced. In times of economic crisis, pandemic, war or any other market mishap, a business can even face more challenges and such misfortunes are stackable.

The primary reasons for an investor to participate in funding a company is for capital appreciation and strategic investment. Capital is the lifeline of a company and in a sound company, the investors will usually expect positive returns or shares appreciation. The other common scenario for investment is to create a strategic channel through vertical integration. A company could strengthen their supply chain by acquiring or investing into their supplier. By doing so, they created more indirect value for their primary business even though the investment might not be fruitful. The lesser reason for an investment could also be buying out the competitors and many other reasons as deemed fit by the investors. Regardless, it is the duty and responsibility for a business owner to protect them and one of the outlines is through market unpredictability.

Personally I would think that creating a balance is the paramount advantage of portfolio diversification against market unpredictability. Unlike internal issues and challenges, the market could move slightly or erratically based on the competition shift and change in any of the PESTLE constituents. Under Porter’s five forces, it covers competition, new entrants, power of suppliers, power of customers, and threat of substitute products. Such factors add new uncertainty into the market which will rock the demand and supply especially for the common industry. The other area of analysis is the political, economic, social, technological, legal and environmental factors. Changes to these factors will usually create a greater turmoil in the market. On the fair note, the market can never be predictable. There could be huge intended forces such as financial institutions or conglomerates that move it but it will be normalised in a matter of time. Having said that, one cannot beat the market but can always join the movement.

To create a balance in portfolio diversification for a company is to ensure there is positive cash flow in the good and bad times. As mentioned earlier capital is the lifeline of a company and commonly a company would not fail if there is enough finances to keep it afloat. The protection of shareholders does not just limit to their shares interest in that company but also to what are the future actions that a company could inflict on them. Of which the common distasteful actions include requesting additional capital injection and introducing new investors without consensus to dilute existing shareholdings. As we can see, there are internal and external factors that a shareholder can be affected. This balance created not only secures the investor and it also generates additional workload for the company. Psychologically speaking, when the company owner is unoccupied, there is a small chance that they would conspire against the shareholders to gain maximum profitability. Being focused on diversification and creating balance for the company would leave such thoughts at their rear.

Under the Ansoff matrix, there are four levels of strategy namely market penetration, market development, product development, and finally diversification. Basically all the levels garner a certain degree of diversification. The market penetration and market development strategies relies on the same product which poses a risk when the product becomes obsolete or when the market demand for it declines. The market penetration and product development strategies relies on the same market which poses another risk when this market collapses. To mitigate such reliance on the same product or market, a full diversification out of the product and market is needed to create the near to perfect balance for the company.

The war between Russia and Ukraine started in February 2022 set a good example to how drastic the market could move at a short period of time. Complacent business owners do not expect an event like this could happen or plan comprehensive mitigation actions. To create the balance the company should adopt a hedging portfolio where the diversified primary and product market is totally different from its existing business. One such case study is the crisis in the automobile industry where many car manufacturers face a manufacturing crunch due to the lack of raw material. Due to the sanction, commodities such as steel and petrol which are largely exported from Russia have come to halt. With increase of petrol prices the petrol vehicle slowed down that could potentially create a rush for electric vehicles. However, the huge price hike in nickel that is a key component for the batteries used in electric vehicles also hindered the entire production. The ideal diversification for such a manufacturer is to enter an hedging industry such as medical or weapon to balance the production and finances.

Unlike recession-proof industries such as household staples, healthcare, and education, they can afford overspecialisation with a totally different approach in the unpredictable market. Diversification could be an option but with the right amount of diversification, the company can also benefit from the balance it creates. The four general diversifications, ordered from the largest scale to the lowest are conglomerate diversification, concentric diversification, horizontal diversification and vertical diversification. For these recession-proof industries, a vertical diversification will fortify the core business through forward or backward integration. As the previous example about manufacturing crunch in the automobile industries, the risk could be mitigated if they own the raw material through backward integration. Owning raw material or commodities however is not a feasible financial option to most car manufacturers. One example of diversification for a recession-proof business is the supermarket where they can acquire certain key suppliers through backward integration and create additional value to the consumer through forward integration. In 2019, COVID-19 has created a lot of inconvenience for consumers to acquire household staples which was alleviated with last mile delivery services. There is little or no change in the demand of such staples but the means to purchase them is affected. Through diversification, such industries can find balance to their business and cash flow once again which also protects the shareholder.

Finally, a healthy portfolio will attract more investment or financing depending on the needs of the company. With more portfolios the risk gets better managed which further pleases the shareholders or potential investors. As most of the risk calculations are based on the company's past performance and benchmark of similar trade, its investability greatly relies on its financial history. Even a company with a balanced portfolio and consistent results could be affected in a market turbulence. How it can tie through the tide greatly depends on the available capital. With its past performance, the existing shareholders may understand and assist in any means necessary as there is no persistent depression thus far in the market. The shareholders could further finance the company or even swap their shares for financing depending on their relationship with the company or the long-term financial benefits. For the shareholders to stand up for the company, first the company should protect them sincerely with proven results. This will create a micro financial ecosystem that continues to bring the company to greater heights.