Why diversify? Diversifying your business can cut your risk—or raise it

Custom Home, March, 2005 by Al Trellis

When clients or friends ask my opinion about "diversification," small alarm bells begin to ring in my head. I want to know what the person means by diversification, and find out the underlying reasons for this change in focus.

The dictionary lists three meanings for diversification. The first is "to give variety to, or to vary." The second is "to extend business activities into disparate fields," and the third is "to distribute investments in order to average the risk of loss." Each of these meanings provides a separate rationale for diversification, if properly applied and relevant to the situation.

Seeking new challenges. If the builder is simply looking for a new challenge because he's bored or tired of the routine, then diversification will probably increase his risk, not dilute it. In the building business, routine is a good thing. There is enough excitement in dealing with new clients and the challenges of building new designs without compounding it by adding new enterprises. This builder needs to find his excitement in other areas of his life. He should take up skydiving or whitewater kayaking to get his adrenaline fix, and leave his smooth-running operation alone.

More likely, the builder may want a different challenge due to burnout from client demands and the constant grind of dealing with unexpected situations. In that case, the builder might want to diversify by increasing the percentage of spec homes he builds or changing the focus of his business.

New market opportunities. A second motivation for diversification may be a perceived market opportunity. If remodeling or light commercial construction is booming in your market, you may want to increase your profits by using your skills to meet the market need. In that case, the danger is that in going after new business segments you may become distracted from focusing on your primary business, leading to profit loss, not gain.

Reduce financial risk. A third motivation may be a desire to protect your financial assets by spreading risk among several different investments. It's the old adage of "Don't keep all your eggs in one basket." And sometimes that's a smart idea. But often it's also a smart idea to do as Mark Twain suggested: "Put all your eggs in one basket. And then WATCH that basket." You need to distinguish between diversifying your investments (nearly always a good idea if risk reduction is your objective) and diversifying your business (sometimes a good idea).

Diversifying your investments means putting the profits from your primary business into other opportunities. Builders historically keep putting all their profits back into the main business. The danger of that is that when a down cycle occurs, everything is at risk. By diversifying investment into other areas, you minimize the risk that a downturn in one area will be economically fatal. You can diversify your investments by buying stocks and bonds, by buying investment properties, or by putting money in businesses owned and managed by others. In all those investments, however, you will usually do better by concentrating in those areas in which you have an understanding of the industry.

Diversifying into other lines of business, however, may or may not reduce your risk. The most risky time for any new business is the start-up phase--when the market is being established. Approximately three-quarters of all new businesses fail in the first year, and about half of those that survive will fail within the first five years. If you are starting a new business at a time when your core business is suffering a downturn, you may actually be increasing your risk.

Diversification may also increase the risk of failure in your core business, since a major cause of business failure is a lack of management focus on key objectives. By trying to run more than one business at a time, management focus can be scattered and ineffective.

There is no simple answer to the question of whether or not you should diversify. It all depends on who you are and what you want. If you are successful at what you are doing, but feel you've saturated your market, then maybe diversification is a good thing. But if you're unsuccessful at home building, there's no guarantee that you won't also be unsuccessful at the new business. The grass only seems greener from the other side. When you get over there, you may find that it's a lovely green shade of crabgrass.

If you decide that you still want to diversity, there are four major diversification options for builders: vertical, horizontal, geographic, and other businesses.

Vertical diversification. Vertical diversification is where you look at the entire process of providing housing to consumers, and try to bring it all in-house. This includes land development, real estate, mortgage financing, and insurance.

Vertical integration usually occurs when a builder becomes larger and volume justifies other operations. There am several problems with vertical integration. The first is that the builder may lack the specific expertise in these related fields, and by taking them in-house, cut himself off from opportunities to collaborate with outside experts. You want those people working with you, not competing against you. The second major problem is that it really doesn't reduce your risk very much. These vertical markets are not countercyclical. When the economy turns down in one area, it generally turns down in all the housing-related areas. In fact, you may be increasing your risk by having all your businesses turn down at the same time.