The long march of diversification — 1500 BCE to today

The long run is a happy place for economists. Harry Markowitz wrote a paper in 1952, "Portfolio Selection," which the Nobel Prize committee waited nearly four decades to recognise (in 1990). Diversification—the subject of Markowitz’s paper—has a longer history than that. The principle of spreading one's bets is as old as man.

We are born diversifiers. The human body itself is a marvel of diversification. As omnivores, we can eat almost anything—an essential trait for surviving ice ages and airport food courts. Human bodies are also notoriously frail and specialised for no specific strength, trait or habitat. Yet by having a diversified skill set, we survive and thrive in all climates, even including Arctic winters.

The ancients knew that for investing, diversification is a survival strategy. Diversification is described in the Babylonian Talmud, wherein we are advised to split a portfolio of assets into thirds: keep one part for business (working capital), one part liquid (gold) and one part in land.

The Talmudic rule of thirds was in recent times tested1 against Markowitz's strategy of optimisng a portfolio per the means, variances and pair-wise correlations of its constituent asset classes. The Talmudic rule did surprisingly well for individual investors, and the math was certainly easier. However, for the institutional investor with a large number of assets and a spreadsheet at hand, the rule of thirds was found inferior to Markowitz's strategy. But that perspective would have to wait another 3,500 years.

About 500 years after the Babylonian Talmud, King Solomon advised investors to "Cast your bread upon the waters, for after many days you will find it again. Give portions to seven, yes to eight, for you do not know what disaster may come upon the land."2 If one could define what asset class counts as casting bread upon the waters, one could also test Solomon's advice.

Diversification remained part of a sound business, if not investment, strategy through the centuries. In The Merchant of Venice, Antonio confided that "My ventures are not in one bottom trusted, nor to one place; nor is my whole estate upon the fortune of this present year." Not putting all one's eggs in one basket was common business and investing sense—particularly as opportunities for individual investing expanded and grew.

Diversification as a means of sheltering wealth against extreme outcomes has a downside of inviting new risks. Benjamin Franklin commented upon how those with large families become a broader mark for sorrow. So it is that with every investment added, the opportunity for a loss increases. Diversification also means a compromise on the rewards that might be reaped from specialisation. Increasing allocations to truly defensive asset classes means accepting a lower expected return.

The Markowitzian diversification of the twentieth century was something entirely new, a finely tuned diversification on the margin which defies this trade-off. By tweaking the allocations and including in the mix assets with negative correlations to the others, Markowitz argued, one can afford to increase allocations to the higher-return asset classes and reap potentially higher returns with lower risk. This is what Burton Malkiel called one of economics' true free lunches. Realising that there is such a thing as a free lunch was a great moment indeed.

1 Duchin, Ran, and Haim Levy, "Markowitz Versus the Talmudic Portfolio Diversification Strategies." Journal of Portfolio Management, Winter 2009, Vol. 35, No. 2: pp. 71–74

2 Ecclesiastes 11:1–2