Chapter 2. Inventing Portfolio Theory
The idea OF diversifying assets to control and manage risk is probably as old as civilization. For as long as people have collected and stored objects of value, preserving and protecting wealth has been part of the human experience. But in the quest to conserve if not grow today's assets for use in tomorrow's consumption, a question arises: what's the best strategy?
Nearly 2,000 years ago, the Talmud counseled: A man should always keep his wealth in three forms; one-third in real estate, another in merchandise, and the rest in liquid assets. Another famous endorsement of diversification made an appearance quite a bit later, in the theatrical voice of the late sixteenth century, when Shakespeare's Antonio affirms the case for diversifying wealth and commercial activities in The Merchant of Venice by reasoning:
My ventures are not in one bottom trusted,
Nor to one place; nor is my whole estate
Upon the fortune of this present year:
Therefore my merchandise makes me not sad.
As a formal inquiry, the strategy of putting one's proverbial eggs in multiple baskets earned a new level of respect when, in 1738, Daniel Bernoulli analyzed risk in his legendary article on the St. Petersburg Paradox. Among the lessons in this mathematical treatise: "It is advisable," he wrote, "to divide goods which are exposed to some small danger into several portions rather than to risk them all together."
In practical application, diversification's appeal has grown more ...