Saturday, 21 January 2012

Margin of Safety Concept in Diversification

Theory of Diversification

There is a close logical connection between the concept of a safety margin and the principle of diversification. One is correlative with the other. 
  • Even with a margin in the investor’s favor, an individual security may work out badly. 
  • For the margin guarantees only that he has a better chance for profit than for loss—not that loss is impossible. 
  • But as the number of such commitments is increased the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses. 
  • That is the simple basis of the insurance-underwriting business.

Diversification is an established tenet of conservative investment. By accepting it so universally, investors are really demonstrating their acceptance of the margin-of-safety principle, to which diversification is the companion.

This point may be made more colorful by a reference to the arithmetic of roulette.

If a man bets $1 on a single number, he is paid $35 profit when he wins—but the chances are 37 to 1 that he will lose.
  • He has a “negative margin of safety.” 
  • In his case diversification is foolish. The more numbers he bets on, the smaller his chance of ending with a profit. If he regularly bets $1 on every number (including 0 and 00), he is certain to lose $2 on each turn of the wheel. 
But suppose the winner received $39 profit instead of $35.
  • Then he would have a small but important margin of safety
  • Therefore, the more numbers he wagers on, the better his chance of gain. And he could be certain of winning $2 on every spin by simply betting $1 each on all the numbers. 
  • (Incidentally, the two examples given actually describe the respective positions of the player and proprietor of a wheel with 0 and 00.)*

* In “American” roulette, most wheels include 0 and 00 along with numbers1 through 36, for a total of 38 slots. The casino offers a maximum payout of 35 to 1. What if you bet $1 on every number? Since only one slot can be the one into which the ball drops, you would win $35 on that slot, but lose $1 on each of your other 37 slots, for a net loss of $2. That $2 difference (or a 5.26% spread on your total $38 bet) is the casino’s “house advantage,” ensuring that, on average, roulette players will always lose more than they win. 
  • Just as it is in the roulette player’s interest to bet as seldom as possible, it is in the casino’s interest to keep the roulette wheel spinning.  
  • Likewise, the intelligent investor should seek to maximize the number of holdings that offer “a better chance for profit than for loss.” 
  • For most investors, diversification is the simplest and cheapest way to widen your margin of safety.

Ref:  The Intelligent Investor

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