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Vertical diversification is a term that derives from the same concept but is applied differently in investments and businesses. When investing, it refers to a strategy of choosing different types of financial assets, rather than just different examples of the same type. In business, it refers to a company taking control of a supplier or customer rather than a competitor.
In all finance-related activities, diversification means engaging in a range of different activities or assets, with the aim of reducing exposure to a particular risk. It’s summed up by the saying don’t put all your eggs in one basket. When investing, diversification means avoiding the risk that a particular failed investment will have serious general consequences. In business, it covers the risk of relying too heavily on a specific element of the market.
Vertical diversification in investing does not refer to the real assets that the investor chooses, such as stocks in three different companies; aiming to increase this variety is known as horizontal diversification. Instead, vertical diversification is about asset types. The idea is that investing in different asset classes will spread the overall risk without overly limiting potential returns.
There are several different ways to categorize assets for diversification purposes. One is for debt products, where the investor effectively lends money to a company or public body in exchange for interest payments, and equity products where the investor buys an equity interest in the company and may be entitled to dividend payments in the future. Another way is to measure comparative levels of risk and return; some assets, such as junk bonds, offer a great return, but with a high risk of not receiving payments. Other assets, such as government bonds, offer a low return, but with a guarantee as close to 100% as an investor can get.
In the business world, vertical diversification refers to the supply chain, compared to horizontal diversification, which refers to competitors in the same market. This means that vertical diversification usually means buying a supplier or a customer. For example, a soft drink manufacturer can diversify vertically 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, to capture a greater share of the money paid by the final consumer.