The term “diworsification” was coined by legendary investor Peter Lynch in his book, One up on Wall Street, to describe the over-expansion of a company into new growth projects and businesses they do not fully understand and which do not align with the company’s core competencies.

The term diworsification has since grown to also refer to over-diversifying an investment portfolio in such a way that it reduces the overall risk-return characteristics.

This article will discuss the meaning of diworsification and its application to portfolio management and business capital investment as well as discussing some real-life examples of diworsification blunders for some fun!   

Diworsification in Portfolio Management

Diworsification is opposite to Markovitz’s nobel prize winning Modern Portfolio Theory (MPT), which preaches that optimal portfolios for a given level of risk and return can be achieved by diversifying across various asset classes and investments with different risk and return characteristics by analyzing how assets interact with each other.

MPT leads to diversified portfolios across asset classes, industries, and geographies. But this diversification can also go overboard, especially for retail investors who lack the sophisticated resources to properly conduct MPT analysis.

In portfolio management, diworsification relates to owning an excessive number of stock positions for the sake of diversification. This can lead to suboptimal investment decisions being made which lower the expected return of the portfolio.

For example, the lessons of diworsification implies that it is not necessary to own an airline stock to get exposure to the industry and partially hedge your portfolio’s exposure to oil companies. Investors should instead own the best businesses with the largest potential returns within their risk tolerance and investment style.

Warren Buffet’s concentrated portfolio in his early days is a good example of avoiding diworsification. Although he was overly exposed to a small number of companies, he did thorough homework on each investment and reduced his risk (but increased his return!) by knowing each business he was invested in inside and out.

“Know your circle of competence, and stick within it. The size of that circle is not very important; knowing its boundaries, however, is vital.“

Warren Buffett

Diworsification in Business Capital Investment

Just as with an investor’s stock portfolio, a business needs to make capital investment decisions that could take the form of organic growth investments, new projects, or acquisitions. Strong management needs to be efficient allocators of capital and invest in the projects with the highest return while also considering risk and the business’s core competencies.

Unfortunately, companies will all too often try to expand their circle of competence which can result in lower return on invested capital for the business as a whole. Such foolhardy new growth projects and acquisitions can be considered diworsification from a business standpoint.

Effective capital investment decisions require analysis, patience and for management to put aside egotistical desires of empire building.

The smartest capital investment decision might be to repurchase the company’s own shares if higher returns cannot be found elsewhere. For businesses with a strong economic moat that is not easily replicated or expanded, share repurchases can often be the best capital allocation decision.

However, strong moated businesses also tend to earn great excess returns and the large amounts of cash flowing around make it hard for management to be patient and put aside the desire for empire building. On that note, let’s take a look at some historical diworsification blunders!

Real-Life Examples of Diworsification

AOL and Time Warner

With the height of the dot-com bubble clouding management’s judgement, historic media giant Time Warner merged with new internet company American Online (AOL) in a historic $350 billion deal announced in January 2000. The widely hyped AOL would own 55% of the combined company as it was valued at multiples twice that of Time Warner despite having half the cash flows.

Due diligence was hastily completed over a weekend before the deal was signed. The synergies from the deal never materialized as the businesses were too different and AOL’s reliance on dial-up internet did not prove to be the way of the future. Time Warner left its circle of competence and this deal is widely regarded as the biggest M&A failure in history.

Hewlett-Packard (HP) and Autonomy

Hardware and software provider HP acquired Autonomy for $11 billion in 2011 to enter the sexy new data analytics business. HP quickly had to then write-down the value of the business by $8.8 billion the following year. While there were claims of fraudulent accounting on the side of Autonomy to inflate the value of the business, the fact that HP was not able to catch the serious accounting improprieties in their due diligence goes to point out the lack of understanding HP had of Autonomy’s business model.

Deere & Co had a health care business…

While not a blockbuster acquisition that will come up on searches for the  biggest corporate blunders, I chose to include tractor and construction equipment maker Deere’s venture into the health care space as an example of bizarre projects management can diworsify into. Starting in 1985, Deere formed John Deere Health Care to commercialize the company’s expertise in the field of health care management developed for their own employee plans.

The health care venture continued for two decades before being sold to UnitedHealthcare for $512 million in 2006. While not an outright failure as the business was marginally profitable, the health care venture definitely strayed away from Deere’s core competencies as a manufacturer and took up valuable resources before management realized they were not able to keep up with the services and technology offered by larger competitors who specialized in the space.    

Takeaway for Investors

While some diversification is prudent, investors should remember to focus on owning the best businesses with the largest potential returns within their risk tolerance and investment style. Be careful not to diversify just for the sake of it.