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 2You’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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Money Bulldog said...

Very well explained!

I suppose the problem with scenario 1 for most people is that the maths becomes less relavent than in scenario 1 due to the extremes of the possible outcomes and that the expected earnings in scenario 1 are impossible, but are possible in scenario 2.

I guess it all comes down to a persons attitude to risk. The more you diversify the more you protect your investment but you lessen your chances of making spectacular returns!

Money Bulldog said...

Sorry, I meant to say the maths becomes less relevant in scenario 2 due to the extremes of outcome!

Mr. Moneybanks said...

Thanks Money Bulldog for your comment(s) ;D
I think you're right. But surely that's simply to do with risk aversion as you allude to in your second paragraph.

Money Bulldog said...

I think my comment was more directed at the rationality of the person. I would argue that in scenario 1 a rational person should always take the 45000 because you can't really apply maths to the scenario due to the extreme & limited outcomes.

The more possible outcomes you have, the more maths can come into the equation and the more you can apply the maths to reason or rationality.

I know that isn't the point of the post though so sorry for going slightly off track, it's just a thought really!

Mr. Moneybanks said...

It's a good and relevant point. But what if we reduced the money to less extreme amounts eg £0 to £10 versus £4.5. Do you immediately take the money or go for the gamble because it's an insignificant amount? Something to think about. It does raise the issue of current wealth affecting current investment decisions.
What do you think Money Bulldog?

Money Bulldog said...

I think it depends what you need the £4.50 for, that may sound silly but if it's your bus home or evening meal the same principle would still apply. I completely agree with you though as the amounts reduce attitudes definately change. keep up the good work Mr. Moneybanks!