At the very outset of Shakespeare’s least loveable comedy, The Merchant of Venice, Antonio is telling his friends of his depression, and how difficult it is for him to account for it. His friends look for possible reasons for Antonio’s sadness, the most likely of which, they postulate, is anxiety about his business dealings. Antonio answers them with an arresting passage which is highly instructive for all investors:
“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.”
No more perfect short statement of the theory of diversification has ever been written. Let us parse his words:
1) My ventures are not in one bottom trusted…
This concept is diversification by vehicle. Even though Antonio is in the shipping business, he spreads his business over several separate ships. This is the familiar portfolio approach to diversification, where it is safer to own several common stocks rather than just one.
2) Nor to one place…
Diversification by geography is covered here. Just as Antonio’s ships have several destinations, so a wise investor diversifies his holdings over different economies to reduce the various risks (political, economic, climatic, even geological) that may come from overconcentration in one part of the globe.
3) Nor is my whole estate on the fortune of this present year…
Another vital concept is diversification by time horizon. Modern investors have more choices than Antonio did in this area. They can hold long-dated and illiquid assets like real estate and private company shares, as well as long-dated liquid assets like public company common shares. They can hold bonds of various maturities, if appropriate. And all investors should always ensure that they have sufficient cash and money market reserves to cover their certain expenditures for two years into the future at any given time.
Of course, we all know that things did get tough for Antonio when more than one of his ventures unexpectedly failed. And, in good 2008 style, he made things even worse for himself by selling a derivative to an investment banker. All in all, it is amazing how timeless the Bard’s advice is, even after 400 years.
Diversify, and avoid derivatives.