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.
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.
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.
- 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
CHAPTER 20 “Margin of Safety” as the Central Concept of Investment
Also read:
Also read:
- Margin of Safety Concept in The Business Venture of Buying and Selling Stocks
- Margin of Safety Concept in Conventional and Unconventional Investments
- Margin of Safety Concept in Speculation and Investment
- Margin of Safety Concept in Diversification
- Margin of Safety Concept in Undervalued or Bargain Stocks
- Margin of Safety Concept in Growth Stocks
- Margin of Safety in Good-Quality and Low-Quality Stocks.
- Margin of Safety Concept in Common Stocks
- Margin of Safety Concept in Bonds and Preferred Stocks
