Putting all your assets in one basket

November 15, 2021
by Noriyuki Morimoto

“Don’t put all your eggs in one basket” is an old saying about diversified investment. It means that you should put each of your eggs in separate baskets, because if you put many eggs in one basket and drop it, all the eggs will break at once.

Separating the baskets does not mean that you can avoid the market price of the eggs moving in the same direction. In other words, separating the baskets may reduce the intrinsic risk, i.e., the possibility of damage to the value of the eggs, but it does not reduce the volatility in terms of simple price fluctuation. However, as long as risk is diversified in the essential sense, volatility can be ignored, and the investment objective can be realized.

If volatility cannot be ignored, you can combine many different ingredients into a single basket so that it has the same value as a certain number of eggs. Since the ingredients are different, they have different price movement patterns, and as a result, the total price of the ingredients in one basket is stabilized, which is an attempt to reduce volatility through diversification.

The intrinsic risk, i.e., the possibility of damage to the value of the assets, can be reduced by diversifying the assets into a number of baskets. On the other hand, volatility, i.e., short-term price fluctuations of each asset, can be reduced by putting together a large number of assets in one basket.

Intrinsic risk reduction through diversification is a matter of asset choice or careful selection based on an analysis of the intrinsic value of assets, not a matter of statistics. On the other hand, volatility reduction by diversification is a matter of statistics, because it is a reduction of random, short-term price fluctuations.

A clear distinction must be made between what can be treated statistically, such as volatility as a random price change of an investment, and what must not be treated statistically, such as judgments about the intrinsic value and risk of an investment.

 

[Category /Asset Allocation]