What Is Vertical Diversification?

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.

Vertical integration is about diversifying across different types of investments, such as stocks, bonds, or precious metals, rather than relying on a diversified set of one type of investment, such as a variety of stock picks.

This form of diversification reduces more risk than just diversifying within a single asset class. For instance, diversifying stock picks could be a smart move within that segment, but what happens when the entire stock market crashes? All those diverse stock picks will tumble. An argument could be made that diversifying within one segment is not reducing enough risk.

With vertical integration, an investor is diversifying their investments across different things entirely rather than diversifying within just one investment class. If the stock market crashes, this investor can still rely on bonds, real estate, precious metals, and art. This vertical integration as a means to reduce exposure to one single market works pretty well. For this investment structure to fail, many different segments must fail, unlike a diverse stock portfolio that fails entirely when the stock market crashes.

Horizontal diversification when investing means picking a variety of different investments within a single sector in an attempt to reduce the risk of keeping all of one's eggs in one basket. Vertical diversification is an attempt to reduce that same risk, but in a slightly different way. Rather than diversifying within one investment segment, vertical diversification is the discipline of investing in different segments altogether.

In the following example, an investment portfolio of precious metals is diversified by owning several different metals instead of putting the entire portfolio in gold. This way, if gold loses value over the next year, the portfolio is still robust because the value of other metals in the portfolio might stay the same or go up, thus reducing the portfolio's overall loss from the drop in gold value.

In the next example, an investment strategy uses vertical integration. This way, if the entire precious metals segment loses value over the next year, the bundle of portfolios is still robust because the value of other investments might stay the same or go up, thus reducing the broadened investment's overall loss from the drop in precious metals' value.

A company might choose vertical diversification over horizontal because it could offer better protection and lower risk. By expanding vertically, the company can gain a revenue stream from an industry it previously did not collect from. Some conglomerate companies such as GE and Honeywell thrive by expanding vertically. This way, if one segment of the company suffers, such as lower jet-engine sales, the other industries the company resides in will continue to provide income.

When Facebook purchased Instagram in 2012, that was an example of a company expanding horizontally. Instagram was seen as a competitor to Facebook because they offered the same type of service within the same business segment.

When Facebook purchased Oculus VR for virtual reality and gaming technology, that was a form of vertical integration. This differs from the purchase of Instagram because the VR and gaming industry is not exactly in the same segment as Facebook and was not seen as a competitor. Facebook lowered its risk in this transaction because the income it receives from the VR and gaming industry is separate from the income it sees from social media and advertising. By having separate revenue streams, Facebook no longer keeps its eggs in one basket.