This is the next post in the 'Getting started with stock market investing' series. If you haven't read the first post about Risk vs. Return, I recommend you read it first.

But divide your investments among many places, for you do not know what risks might lie ahead. - Ecclesiastes 11:2

Unexpectedly, the bible can be the source of solid investment advice. We ofcourse all know the saying "Don't put all your eggs in the same basket" and by now it seems so obvious that it has almost become a cliché. But while it seems obvious after a superficial glance, it is actually a bit more involved to understand in depth.

Imagine that you invest in a company that produces bottles of sun screen lotion. The company is appropriately named Solar Protection Inc. .

With the word 'invest', I am referring to the activity of buying a number of shares and as a result becoming part owner of a company (a 'shareholder'). As a shareholder, you are entitled to part of the profits (proportional to the percentage of shares you own). When the company does well, you share in the company's good fortune but if the company does badly you also receive part of the blow.

But let's get back to the story.

This year's summerperiod is a lot sunnier than the past year. While the average person may just be happy that he can spend more days on the beach, Solar Protection Inc. is quite a bit happier. The company's production plants can barely keep up with the demand for sun screen. People rub the greasy liquid faster on their skin than Solar Protection Inc. can manufacture it. Profits are reaching sky-high levels.

Eventually the summer months come to an end. The company executives pat each other on the backs and organize a round of bonuses to congratulate each other on the major success that was past summer.

But then, 6 months later, disaster strikes. In direct contradiction to the long-term climate change trend, the summer of next year is unexpectedly gloomy. The number of summer days is at an all-time low and beach facing hotels are having a rough time. For Solar Protection Inc., this is just short of armageddon: employees are standing idly at their work stations and the executives take a lot of heat from the big shareholders, who are powerless in watching the share price plummet. While the company doesn't go bankrupt, this summer teaches the executives to fear the weather factor.

An interesting question can emerge at this point: given that Solar Protection Inc. was so sensitive to the number of sunny days in the summer months, why didn't they take out some kind of 'insurance' to counteract this risk? After all, we all have a fire insurance in case our house burns down, why didn't Solar Protection Inc. do the sensible thing and cover themselves on this aspect?

While Solar Protection Inc. has active insurance policies in place protecting its bottom line against a whole range of other factors: factory fires, strikes in the workforce, fluctuations in the interest rates etc., they would never take out an insurance policy against the weather in summer. To explain this, we have to take a look at the expected return and variability of the company over time. In the figure below, the value of your investment is plotted against time. You can see that this value is highly dependent on the weather in summer...

Given that we don't expect the company to go bankrupt and that it seems quite healthy (as proven over the last few years), we have a long-run trend which is clearly positive. The variability over time, however, is highly dependent on the amount of sun during a particular summer: a sunny summer results in a peak while a gloomy summer results in a valley. (The amount of sun is ofcourse not the only factor generating variability but let's assume for this example that the company has taken out insurance policies against all other random factors)

Imagine that the company decides to take out an insurance policy against the weather in summer. In return to paying a yearly premium, Solar Protection Inc. would get a certain amount of money if the weather in summer would prove to turn out badly. However, if the summer would be especially sunny, the company would pay a certain amount of money to the insurance company. Ofcourse, the amount of money paid or received would never totally cover the variability of a particular summer but would go a certain way in demping the huge peaks and valleys:

We see that the variability (risk) has decreased significantly. The peaks are not that high anymore while the valleys are hardly valleys anymore. On the other hand, we see that the return over the long-term has decreased significantly. This is due to the insurance premium! Any insurance company who is ready to assume Solar Protection Inc.'s weather risk would only do this if it is compensated adequately for it. If you remember the first episode of this blog series, this is not that surprising: in a correctly functioning market, assuming additional risk will always be rewarded with increased returns.

Why would Solar Protection Inc. not do this? In fact, this course of action would be heavily opposed by the shareholders!

This is not because shareholders prefer high risk-high returns over low risk-low returns but because the shareholders feel that they can mitigate the risk (=variability) themselves in a cheaper way.

We all can easily imagine a company which does well when Solar Protection Inc. does badly: let's say an umbrella company, appropriately called Umbrellas Corp.

Interestingly, their bottom line is also highly dependent on the weather but in the exact opposite fashion as Solar Protection Inc.: rain is good and sun is bad! Assuming that Umbrellas Inc. is also well-run and can expect the same long-term returns as Solar Protection Inc, you get the following plot:

This observation is ofcourse no rocket science. And you know who else figured this out? Yes, you're right: the shareholders of Solar Protection Inc. They have figured out that if they invest the same amount in Solar Protection Inc. as they do in Umbrellas Corp, they could obtain something like the following risk-return profile:

Do you remember how I said that you always have to trade off risk versus return? The more return you wish to obtain, the more risk you have to be comfortable with? Apparently, diversification is an exemption to this rule!

Diversification allows you to decrease your risk exposure without a loss in return on investment

Ofcourse, if you as investor are overwhelmingly sure that Solar Protection Inc. will have a far greater return on investment over time than Umbrellas Corp. (maybe because you have insider knowledge that Umbrellas Corp. is badly run or that you believe that rain will become a thing of the past), you have no business in also holding shares of Umbrellas Corp. If you hold this belief and you still diversify, you will just lower your overall returns and end up with the average return of Solar Protection Inc. and Umbrellas Corp. (nevertheless with lower variability/risk). Diversification is a valuable strategy if you acknowledge that you don't know more about the companies you invest in than the market as a whole. This brings us to the efficient-market hypothesis (EMH), which will be discussed in a later post.

The take-away from this post:

If you invest in companies and sectors of which you reasonably don't have a knowledge advantage over the market as a whole, you will do well by diversifying: by holding stock in companies which are differently affected by random factors, you will decrease the risk/variability of your portfolio without losing return.