Diversification Deconstructed

Discussion diversification in depth with an example to help clarify ones understanding of diversification and its benefits.

Several months ago I wrote a guest post for Wealthartisan.com about diversification. I want to take the time to recreate some of those ideas for my readers here at MultimillionaireRoad.

Diversification Defined

I first defined diversification in a recent article. Briefly, diversification means to reduce risk via investing into a variety of assets. Unless the portfolios individual asset components change together, a diversified portfolio will have less risk attached to it than the average of the individual components added together.

Developing Diversification

In the original article over at Wealthartisan I explained exactly what diversification was through the help of an example. I will reproduce a similar example here.

SCENARIO 1: You’re on a game-show and the host offers two choices:

The host tells you that he will flip a coin. If heads you receive £100,000. If tails you leave with nothing. Alternatively, there will be no flip and you can have £45,000 now.

What do you choose?

Some people take the money and run, preferring to have something guaranteed, rather than risk getting nothing. Other people figure that they came with nothing and might as well take the chance to walk away with $100,000.

Let's look a little closer at the maths. Your expected earnings from the coin flip is £50,000 (1/2 X £0 + 1/2 X £100,000). Since this is £5,000 more than the £45,000 a rational person should take the gamble.

SCENARIO 2: You’re on a game-show and the host offers two choices:

This time the setup is different. The host tells you that he will flip ten coins. Each coin will be worth £10,000 if it lands on heads. If the coin doesn’t land on heads then you get nothing from that particular coin. However, you do have the other nine coins to rely on.

Alternatively, you can have £45,000 now without any coin flipping, just as in scenario 1.

What do you choose?

This scenario appears different to the first one. Some people reason that with ten chances to get £10,000 you are very unlikely to walk away with nothing so you might as well take the gamble. Other people may disagree and argue that they would still rather have £40,000 guaranteed.

Diversification Discussion

The expected payoff in scenario 2 is no different from scenario 1. You’re still expected to get £50,000 from the gamble in scenario 2 (1/2 X £10,000 + 1/2 X £10,000 + 1/2 X £10,000 + 1/2 X £10,000 + 1/2 X £10,000 + 1/2 X £10,000 + 1/2 X £10,000 + 1/2 X £10,000 + 1/2 X £10,000 + 1/2 X £10,000). Contrary to the maths I am sure that more people are willing to take the gamble in scenario 2 than in scenario 1.

Why does your decision to take the gamble change?

In scenario 2 the risk is spread across 10 different assets rather than risk it all in one flip. Of course your returns may not be as high as the first gamble but then again your losses are not as low. This is the benefit of diversification. It sustains wealth across many different outcomes.

Readers what do you choose to do in each scenario? Does your decision change?

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