Horizontal diversification is when you hold different instances of the same asset class. In this form of portfolio diversification [1], you’re trying to reduce localised or industry sector specific risks.
A broad index-based ETF is a good example of horizontal diversification.
The classic example of horizontal diversification given in textbooks involves the weather, and two companies:
- Company A makes ice-cream
- Company B makes umbrellas
Imagine you’re investing in a universe of just these two companies.
If the weather is sunny, Company A will make a killing in the heatwave and its share price will rise, while Company B will suffer.
If it rains for weeks on end, nobody will feel like an ice-cream and revenues will fall at Company A. On the other hand everyone will want an umbrella, so Company B will triumph.
Hold them both and you get the best (and worst) of both worlds.
What if people stop going outside altogether? Better hope you’re invested in Company C, which makes televisions.
The ultimate in horizontal diversification is to buy an index tracker [2] or ETF, so that rather than trying to work out which particular companies will flourish, you instead track the overall performance of the stock market by investing a small amount in every company listed in that index.
If you hold an ETF tracking the S&P 500 or the FTSE 100, your risk is spread across 500 or 100 companies, respectively.
However unlike with vertical diversification [3], you’re still exposed to the risks of one asset class, in this case equities.