Diversification is Investing’s Free Lunch

The wisdom of diversification in money management, as encapsulated in the old proverb “don’t put all your eggs in one basket” is an idea that has been around for thousands of years.

An ancient Jewish writing known as the Talmud, written between 1,200 BC and 500 AD, contains this advice: “Let every man divide his money into three parts, and invest a third in land, a third in business, and a third let him keep in reserve.”

Writing in the late 1500s, Shakespeare, in his play The Merchant of Venice, has Antonio, the title character in the play, say: 

“Believe me, no.  I thank my fortune for it – My ventures are not in one bottom [ship] trusted, Nor to one place, nor is my whole estate, Upon the fortune of this present year.  Therefore, my merchandise makes me not sad.” 

One of my favorite financial writers, Larry Swedroe, goes so far as to call diversification investing’s only free lunch.  How is diversification a free lunch?  Swedroe states, “The reason is that diversification reduces the risk of investing in equities without reducing expected returns.”

Ships & Diversification

Imagine you are a merchant in Europe during Shakespeare’s time.  You make your living shipping goods to and from the New World.  You own a single ship that can make one round trip voyage a year, and if the voyage is successful you make 100,000 pounds.  Imagine, also, that about one of out every ten ships making the round trip voyage to the New World is lost due to shipwreck, pirates, or other mishaps.  Your expected income every year would be 90,000 pounds, calculated as follows:

100,000 pounds multiplied by 90 percent probability of success = 90,000 pounds

In reality your income would probably be either 100,000 pounds or zero.  Every voyage would carry a significant risk of catastrophic loss.

Imagine, instead, that you go into business with nine friends who own ships similar to yours.  You now own 10 percent of a business with ten ships, each capable of making 100,000 pounds per year.  You have taken the advice of Antonio, the Merchant of Venice, and not put all your ventures in one bottom, but diversified.  Your expected income is still 90,000 pounds, as follows:

1,000,000 multiplied by your 10 percent ownership, multiplied by 90 percent probability of success = 90,000 pounds

While your expected income is the same as it was previously, your risk of catastrophic loss has been greatly reduced.  You have received a free lunch by reducing your risk of catastrophic loss without decreasing your expected income.

Stocks & Diversification

As with ships, so with stocks.  A fundamental law of investing is that there is no reward without risk.  However, you are only rewarded for risk that cannot be diversified away.

The stock market has returned about 10 percent per year for the last 100 years.  If you invest in the stock of a single company your expected return is 10 percent per year.  If the company is extremely successful you might make much more than that, but if the company goes out of business you could lose your entire investment.

If you diversify by investing in a mutual fund your expected return remains 10 percent, but your risk of losing everything is reduced to close to zero.  As with shipping, diversification acts as an insurance policy against catastrophic loss without reducing expected return.

However, diversification is not an entirely a free lunch.  The cost of the downside protection is giving up the possibility of striking it rich by investing in the next hot technology stock when it is small and unknown.

Regular readers will not be surprised by my advice that the cheapest and easiest way to diversify is by investing in low cost index funds.  So take the advice of the Merchant of Venice, and don’t put all your ventures in one bottom, or all your investments in one company.  It might not quite be a free lunch, but it is most definitely a wise move.