London

“DON’T put all your eggs into one basket” is the layman’s expression encouraging diversification. This was put into mathematics in a financial context by Harry Markowitz in the 1950s, in his Modern Portfolio Theory. He showed how to construct a portfolio of financial assets so as to maximize expected return for any given level of risk. This idea has inspired much theory and practice of investing, at all levels.

Only last month my bank manager had me complete a questionnaire so he could figure out how much risk I was comfortable with, and then he gave me the computer-generated result that told me how much of my money should be in cash, how much in bonds and how much in stocks. So with your grandmother telling you what not to do with all your eggs, your bank manager giving similar advice, and Professor Markowitz, a Nobel laureate, backing this up with mathematics, you’d expect that traders in banks would have got the message. Yet as the following simple thought experiment shows, it is not quite so straightforward.

It is your first day in your first job out of business school. You are going to be a trader in an investment bank! You will be rich! You will retire by the age of 30 and spend the rest of your days doing charitable works (when not on your yacht, of course). You are shown to your desk and introduced to your fellow traders. You notice something very strange, that they are all making similar trades using similar financial instruments. That’s odd, you think, there doesn’t seem to be much diversification going on.

Never mind, you are going to put into practice everything you’ve learned in school, and that includes diversification, so your trades will be safely diversified from those of your colleagues. Now to see if that makes any sense, we’ll put some numbers to this, and imagine what could happen to your plans for buying that yacht. Does diversifying improve your chances of getting a big bonus?