How many eggs in each basket?

The first rule of investing is "diversification". Or better said, "don't put all your eggs in one basket". What little is said or explained is "how many eggs in one basket". Thus, as important as "what to put" is "how much to put".

There is plenty of evidence and market stories that attribute the failure or poor success of many investment portfolios to the wrong balance of assets, more or less risky. Without much effort we come across sad stories of lost fortunes. And not because the owners spent excessively. Nor because they invested in bad assets. But mainly because they put too much in risky assets, and little or nothing in conservative assets. Surrounding this dilemma is an accumulation of investment science and discipline. I will try, in simple terms, to shed light on these principles.

In the September 23 edition of this year, The Economist reviews a recent book on the subject: "The Missing Billionares". The book starts with anecdotes about fortunes that seemed to last forever and in a few years turned to dust, precisely because the amounts did not balance the risk-return of such investments.

The book begins by describing the results of an experiment in which a group of students were given an amount of money to bet on the successive toss of an altered coin, where the outcome was not 50/50 but 60/40 in favor of one side. The students could invest any amount they wanted in each coin toss and the rules put a maximum cap on how much they could win. Everyone would have expected that with such an advantage, knowing which side would come out ahead of the other, everyone would have come out ahead.

In reality, the majority lost everything and only a few achieved the maximum. Why, if everyone had the same advantage? Because what really determined the outcome was, what amount you invested or what investment strategy you had throughout the game. If you were very aggressive in the amount you bet, you could win more. But if you lost, you had less resources to continue betting and you would probably not recover. If, on the other hand, you bet too little, you could lose little, but your ability to grow much was also limited.

The winners of the game were those who had a consistent strategy, betting a proportion of what they had, whether more or less. And some, having already won enough, bet a little more to see if they could reach the maximum, but without risking too much of what they had already won. This game describes the importance of sequential proportions in an investment strategy.

A saver who only puts his money in conservative and safe bank deposits. He will most likely have a predictable return and at the end of his productive life, net of inflation, he will have a modest capital accumulation.

At the opposite extreme, another investor, with the same amount of initial money, invests in a single asset that promises high returns, but obviously, with a great risk of losing all or part of what was invested. At the end of his productive life, this investor may end up with nothing, with only part of what he invested or with much more accumulated than the saver.

Now, those who combine assets of various risks should enjoy the best of both worlds. But there are losers and winners here too. A good part of the reason is due to the composition of the assets.

Touching on more technical aspects, the book offers some formulas to determine the rational proportion of investment to its risk, and these formulas are tied to three important premises. First, that, for that asset, with an uncertain outcome, its risk can be measured.  That the investor recognizes the subjective value or what economists call the utility in each investment and what follows from it, that your gain or loss in money is not the same as the positive or negative change in your welfare,

The book explores several ways to determine that ratio and the simplest is what is known as the "Merton Portion." (The Merton Share) developed by the financial economist and Nobel laureate Robert Merton. The simplified formula for that ratio would be the expected return divided by the standard deviation of that return, but multiplied by the investor's degree of risk aversion. The formula reflects the assumptions stated above.

There are other formulas to establish this ratio, some of them more complicated, which take into account the increase or decrease in the value of the asset over time and thus adjust the ratios.

I would like to conclude by telling clients and investors that, first, how many eggs go into each basket is important. Second, that in order to determine these ratios, the explanation of which requires technical and statistical knowledge, you should be assisted by your financial advisor or broker. Lastly and most importantly, know what risk and what peace of mind you want to have when undertaking this process.

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