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.
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.