Diversification

Diversification Demystified

One of the important features of becoming and preserving your multimillionaire status is diversification. So as not to be too technical, the following is a brief definition of diversification from the Wikipedia:

“Diversification means reducing risk by investing in a variety of assets. If the asset values do not move up and down in perfect synchrony, a diversified portfolio will have less risk than the weighted average risk of its constituent assets, and often less risk than the least risky of its constituents.”
- Wikipedia, “Diversification in finance“

It is not immediately intuitive how diversification of assets,  creating multiple income streams reduces your risk. Ideally you want to try to maximise your returns but reduce your risk - fair?! The following story should demonstrate the benefits of diversification. Story time...

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

“I am going to flip one coin. If it’s heads you get £10,000. If it’s tails you leave with nothing. However instead of the coin flip I can offer you an alternative: I won’t flip the coin and you can have £4,000 right now?”

What do you choose?

Some people take the £4,000, say thankyou very much and run. These people preferto have something guaranteed, rather than risk the possibility of receiving nothing. They may never win £10,000, but they won't walk away with nothing either. 

Other people reason that they came with nothing and might as well take the chance to walk away with £10,000. They gamble!

But what do you do?

Before you answer let's think about the problem mathematically.  Probability states that your return from the coin flip is £5,000 (1/2 X £0 + 1/2 X £10,000). Since this is £1,000 more than the guaranteed £4,000 a rational and risk neutral (totally indifferent in their risk tolerance) person should gamble rather than accept £4,000.

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

“I am going to flip ten coins. Each coin will be worth £1,000 if it lands on heads. If the coin lands on tails then you receive nothing from that particular coin. Although you will have 9 other coins to flip. Alternatively, instead of any coin flips you can have £4,000 now?”

What do you do? 

On the surface scenario 2 appears different to scenario 1. You may think that you now have ten chances to get £1,000 at least and so you are unlikely to walk away with nothing. As such you take the gamble rather than the money. Alternatively you may disagree and argue that you would still rather have £4,000 guaranteed.

What do you do?

Again, let's consider this problem mathematically. Theoretically, your pay-off in scenario 2 does not change from scenario. In both scenarios you are statistically likely to walk away with £5,000 from the gamble (1/2 X £1,000 + 1/2 X £1,000 + 1/2 X £1,000 + 1/2 X £1,000 + 1/2 X £1,000 + 1/2 X £1,000 + 1/2 X £1,000 + 1/2 X £1,000 + 1/2 X £1,000 + 1/2 X £1,000).  Regardless of the expected payoff being £5,000 I would speculate that more people were willing to take the gamble in scenario 2 than in scenario 1.

Why is this the case, especially considering that the expected payoff is the same?

It is because in the second scenario the outcome is spread across 10 different coins  rather than risking the outcome all on one flip, as in scenario 1. That is diversification - spreading the risk.

In scenario 2, with 10 coins your returns will almost certainly not be £10,000, but then again you're very unlikely to walk away with nothing. This is the benefit of diversification. It helps sustain wealth across many different outcomes.

Did you take both gambles? Let us know in the comments!

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