2.3 Risk of Multiple Assets (Portfolio Risk)

"Put all your eggs in one basket,
and then pay very close attention to that basket."
—Warren Buffet

Why are we told not to put all our eggs in one basket? If we had two baskets and we tripped, might we not lose both baskets anyway? Or if we tripped, but caught ourselves with our right hand, might we not save the full basket in our left hand? What are the assumptions implicit in the eggs-in-one-basket dictum ?

2.3.1 - Portfolio theory

Risks do not exist in isolation. An event that may have an adverse effect on one financial asset may have a beneficial effect on another. Risk should be seen as affecting the overall returns of a group -- or portfolio -- of assets. (More 2.3.1>>)

2.3.2 - Covariance defined

As we have seen, for diversification to work there cannot be a perfect correlation between the returns on different assets. When one is down, the other must be up -- and vice versa. (More 2.3.2>>)

2.3.3 - Diversification

Combining negatively correlated assets can reduce the overall variability of returns -- or risk as measured by (lower-case sigma). This is known as diversification. (More 2.3.3>>)

My ventures are not in one bottom trusted,
Nor to one place: nor is my wole estate
Upon the fortune of this present yea:
Therefore my merchandise makes me not sad.

Antonio, Merchant of Venice
Act 1, Scene 1
William Shakespeare