The Mathematics of Money

290 Chapter 6 Investments

steal all of Zarofire’s customers, that the company would not be crippled by unexpected

product failures, lawsuits or scandals, that the economy would not fall into a recession

destroying the demand for Zarofire’s products, that the stock market would not fall over-

all dragging stock prices down in general, or that some other misfortune would not strike

the company from out of the blue. As it turns out, none of those things happened and the

stock turned out to be an excellent investment. But at the time you bought, and during

the time you owned the stock, these risks were still possibilities that you could not have

ruled out.

Diversification

There is no way to entirely avoid risk, in finance or in life. However, there are ways

to manage risk. One simple but powerful way to do this is through diversification.

Diversification can be summed up by the old adage “Don’t put all of your eggs in one

basket.” To illustrate how diversification can work with investments, suppose that you

are considering investing in one of four different companies: Axerixia Corp., Blun-

derbluff Industries, Caughdenoy Container Corp., and DDKind Cuts Hair Salons. You

have every reason to expect that each of these four companies will be very successful,

and that investing in them will be profitable. How do you decide which of the four

stocks to invest in?

Let’s gaze into the crystal ball (obviously impossible in real life, but we can pretend for

now). Suppose that the table below gives the prices of each stock at the end of each of the

next 12 months:

Axerixia Blunderbluff Caughdenoy DDKind

Start $20.00 $20.00 $20.00 $20.00

1 $17.77 $22.50 $22.47 $21.25

2 $18.03 $26.75 $19.76 $20.17

3 $23.98 $18.05 $21.99 $26.55

4 $24.24 $14.44 $28.65 $25.99

5 $28.55 $12.65 $33.13 $21.06

6 $26.27 $11.64 $37.41 $21.11

7 $25.03 $9.47 $39.63 $24.44

8 $28.02 $10.43 $41.56 $20.01

9 $32.77 $6.18 $42.46 $19.11

10 $35.09 $3.61 $43.43 $18.50

11 $31.82 $2.05 $49.23 $18.77

12 $28.52 $1.54 $50.98 $20.00

Now, if you did have this crystal ball, you would have known that you were wrong about

Blunderbluff’s prospects, and that in fact that company’s stock would be a dreadful

investment. You would also have known that Caughdenoy would be the best performer

of the group, and would thus have known that you should invest all of your money in that

company’s stock.

But this is of course all a fantasy—no one actually has this sort of information in

advance. Given this reality, what is your best course of action? You could just pick one of

the four at random and cross your fingers. Doing that, you have a 1 in 4 chance of picking

the best performer—but you also have a 1 in 4 chance of picking the worst. You could try

to select the best one, but there is still a good chance that you will be wrong, either because

of an error in judgment or because something that you didn’t know about or couldn’t have

anticipated may happen.

An alternative, very reasonable, choice might be to divide your investment among these

four stocks. What if, instead of investing your entire $10,000 in just one of the stocks,

you decide to invest $2,500 in each of the four? In this example at least, that would have

worked out quite well.