Where Diversification Comes From

Ininvesting, diversification is something that virtually nobody questions. We all assume that it’s a good thing and the more of it the better. Today let’s think a bit about where the benefits of diversification come from. First, let’s review why diversification is generally a good thing. Imagine you have the opportunity to flip a coin once. If it comes up heads you win $2.00 and if it comes up tails you lose $1. This has an expected payoff of: <pre> 0.5*2.0 + 0.5*-1.0 = 0.5 dollars</pre> That’s a positive expected payoff so you should probably flip. Still half the time when you do flip you will end up losing whatever you put up. So there is risk. If a very large number of people were to wager all they had on such a coin flip, roughly half would walk away up 200% and half would walk away broke. There’s no happy medium, its either financial bliss or destruction. Thus, it would be unwise to risk your entire life savings on one flip of such a coin. Still, because of that nice expected payoff, you would want to wager at least something. Now imagine if instead of having the opportunity to flip one coin once, you could instead flip two coins simultaneously once, where each coin promised the same payoff as before. If you split your bet evenly across the two coins, the possible outcomes look like: <a href="https://medium.com/alpha-beta-blog/where-diversification-comes-from-85e3dfc8f3de">Website</a>