The best tools available for investors to mitigate risk, and reap the benefits from the stock market, are diversification and time, if you could add a third one it would be luck.
Of this trifecta, as you may realize, it seems that diversification is the variable on which one has more control. As for the time, despite having the intention and commitment to a broad horizon of investment, no one ever knows what surprises tomorrow might bring, and our strategy can be abruptly halted by any surprise or emergency.
By diversification, we refer to putting into practice the old and well-known saying: “do not put all the eggs in one basket”.
Now, the meaning of this advice goes beyond a random exercise of adding different stocks just for the kicks. The modern portfolio theory indicates that there is an efficient barrier, where by choosing different uncorrelated assets, an optimal combination can be achieved.
That means, we could aspire to an additional unit of return, without necessarily increasing our portfolio by a unit of risk.
In the blacksmith’s house, a wooden knife
One of the main precursors of this portfolio theory was Harry Markowitz, economist who in 1990 won the Nobel Prize in Economic Sciences for his work in Efficient Portfolio Selection (1952–1959).
It is worth mentioning that when he was inquired about his real-life portfolio, and the results obtained after applying the model to his own case.
“My portfolio has a weighting of 50 percent equity and 50 percent fixed income.”
This was a clear example that one of the most recognized economists acts more like a sapiens than an econ, under the definitions of Richard Thaler.
What hope is left for the rest of us without Nobel prizes, yet?
I think that his strategy, despite being deemed as “non-optimal” achieves an important part of diversification’s objective: to reduce the risk.
On one occasion somebody told me: “there are more than five hundred strategies to generate profits, but to lose everything, the cause is always one, a poor risk control.”
This poor control of risk has a negligent nature. Sometimes an investor will accept to engage in risky positions, if the favorable scenario warrants it, but he should avoid being exposed to a “tail event” (or that holds a minimum likelihood) that erases his capital.
We can define this risk as a risk with a zero product property. We know that when multiplying several products, if one of them is zero, the result will be zero.
Diversifying in the sports world
Delving deeper into diversification I would like to bring some examples from the sports betting world in order to shed light into some basics and misconceptions.
While some claim to bet with a diversified system, the fact is that “the house” always has an edge. It charges at both ends and when paying out to the winners, it holds a profit for itself.
There are those who “diversify” by betting on several games. Here are two ways to do it, one is to place all bets independently, or all of them through a parlay.
The first option would be the most comparable with “diversification” although not the most thrilling. On the other hand, the second option offers larger returns in case of reaching several results, the main problem is that it would leave them “exposed” to the “zero product factor” and would fail by definition in risk control.
Let’s suppose that someone identifies six games where he estimates that his picks have a 66 percent winning probability in each match. What is the probability that “all” will be fulfilled? 0.66 x 0.66 x 0.66 x 0.66 x 0.66 x 0.66 = 8.3 percent … there would be a 91.7 percent chance of ending with “zero”.
What’s more, this bettor could have 90 percent “certainty” and the compound probability would be slightly above 50 percent.