V.9:5 (214-215): Diversification And Risk by Raymond Rothschild

V.9:5 (214-215): Diversification And Risk by Raymond Rothschild
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Diversification And Risk by Raymond Rothschild

No method of stock or equity selection is perfect. Even the best of schemes can fail. For example, suppose we had a system of selecting stocks with a probability of success of two thirds. The probability of failure, then, would be one third. The odds of success versus failure are therefore 2 to 1. Assume for the moment that we invested our total capital and that each time an investment succeeded we would double our money, but a failure would result in a complete loss. A1-though the probability of winning on the first try is good, a high probability of losing everything would still exist as the number of trials increased. There must be a better way of managing our money.

Actually, if we had an unlimited amount of capital and invested in smaller equal amounts, eventually two thirds of our choices would be winners and only one third would be losers. In the long run, we would be sure winners óbut in the long run.

A MORE OR LESS REAL WORLD

We live in a real world, however, wherein the average investor does not have an unlimited amount of money. Can the risk of loss be reduced? Yes, provided we divide our starting capital into smaller equal amounts. Suppose we apportioned our total purse into five equal shares. How would that affect the outcome? (The details of the probability distributions are shown in the sidebar entitled "Probability considerations.")




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