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Diversification: How to Spread It Around

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Economics

Diversification is an important word in the study of business and economics. It shows an appreciation for "the big picture" and planning for the future.

Diversification can best be described by the following phrase: "Don't put all your eggs in one basket."

That means several things, depending on what part of economics we're discussing. In every case, though, it means to spread out your money or your time or your other resources.

Let's take the example of the lemonade stand. You operate a neighborhood lemonade stand. You live on a busy street, and people walk by your lemonade stand all the time. On hot days, people will want more lemonade than on cooler days. Some people will want lemonade every day. However, on icy cold days, almost no one will want ice cold lemonade.

If you spend all your time and money making big pitchers of lemonade and it's snowy and freezing outside, then you'll sell hardly any lemonade. You might have spent just as much making that lemonade as you did on a hot, sunny day, but the money that you'll get for your troubles will be next to nothing. If you counted on that income to pay for your admission to a new movie or as part of saving up for something special, you'll be very disappointed.

If, however, you made yourself available to shovel the driveways and sidewalks of your neighbors instead of operating your lemonade stand all day, you might find yourself with quite a bit of money at the end of the day. Neighbors who have to get to work will likely gladly pay you a handful of dollars to get the snow off their driveway and sidewalk.

Want a more realistic example? How about a company that spends thousands of dollars to buy a big herd of cattle, with the intent to slaughter them and sell them as beef? That's all well and good until the herd develops Mad Cow Disease or something similar and no one wants the beef. You've already spent your money, but you get nothing in return.

If that company has poured all of its money into the cattle herd, then it has nothing to show for it. If the company borrowed the money, then it will have to pay back the loan without having income from the beef, income it was counting on.

If this company had diversified, however, things might not be all that bad.

Let's say that the company also bought a lot of chickens, with the idea of raising the chickens and selling the eggs they laid. Assuming that nothing bad happens to those chickens and their eggs, the company can expect to sell lots and lots of eggs and get lots and lots of dollars in return. If the company buys both cattle and chickens and the cattle herd goes bad but the egg market is good, then the company won't be totally broke because the money brought in from egg sales will offset the money lost from the bad cattle. The money lost might be more than the money gained, but it's still better than a total loss, which is what it would have been if the company had spent all of its money on a cattle herd that went bad.

Diversification is a key concept in investment as well. Many investors will buy many different kinds of investments, such as stocks, bonds, gold, and property. If you own shares in several companies and one of them goes bankrupt, it means that you won't get any money from selling the stock that you own in that company. However, you still have shares in other companies and can expect to get money if you sell the shares you have in those companies.

In the same way, if you own a home and also have lots of money in the bank, you won't lose everything if the home you have suddenly burns to the ground. You'll still have that money in the bank. You can collect insurance for your home, but that often doesn't begin to cover what you really lost in the fire, which is your prized possessions.

Diversification is a rather long word. It has a simple definition, though.

 
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