Effect of Portfolio Diversification on Financial Performance of Investment Firms in Kenya

Abstract

Portfolio diversification has been found to be a strategy that once well adopted, would ensure that investment firms maximize profit. This comes from the fact that investments involve risk taking ventures, that if the total exposure by an investor is not well calculated and determined, then it would have a negative impact on the returns. This study therefore sought to determine the effect of portfolio diversification on the financial performance of investment firms in Kenya. To achieve this objective the study collected secondary data from 29 relevant financial publications which summed up to a 64.4% response rate of the population of 45 investment firms. The study used Spearman’s correlation to determine the correlation between the study variables. This was driven by the fact that Spearman’s Correlation is a non-parametric measure that was desired in this study. Portfolio diversification index together with size had significant correlation, though HHI (index) had a positive of 0.684 while size had negative correlation of -0.327. It showed that increasing diversification index had a positive impact on performance, while increasing the size of the firms led to diseconomies of scales. Capital structure and liquidity on the other hand had insignificant and weak correlation (were almost equal to zero). This indicated that these factors did not have significant impact on financial performance. The analysis was undertaken further where regression analysis was adopted by the study. A Hausman test that was carried out indicated, that a random effect model was appropriate for the study. The model uses chi-square test to determine the significance of the effect between portfolio diversification and financial performance. The p value was less than 0.05 indicating that there was a statistically significant effect. The coefficients were all significant apart from Liquidity that was insignificant as p value was greater than 0.05 at 0.064. This indicates that if all factors were held constant and portfolio diversification index increased by one unit, performance would increase by 2.52%. Similarly, increasing debt over equity by one unit for investment firms in Kenya, their performance would increase by 7.07%. Increasing liquidity on the other hand, while holding all other factors constant would lead to a decrease in financial performance. A similar effect would be obtained if the study increased the size of firms, by increasing the amount available for investments would lead to a decrease in financial performance of 2.34%.