- We don't like risk.
We have to be paid to bear risk,
but some risk can be reduced through diversification.
Diversification is just a fancy way of saying
don't put all your eggs in one basket.
If you put all your eggs in one basket and you trip,
you've ruined all your eggs.
But if you spread your eggs around,
you've diversified your risk.
Professor Harry Markowitz won a Nobel Prize
for mathematically proving this statement,
don't put all your eggs in one basket.
It's a way to reduce risk by spreading your risk around.
Now, some risks are avoidable,
and some risks are unavoidable.
For example, think about job risk.
If I'm a construction worker, I'm working in a risky place,
a construction site.
Don't expect to be paid extra
for bearing risk that could be avoided.
You can avoid a lot of risk by wearing a hardhat.
So you're not going to get paid extra
for not wearing your hardhat.
Companies have risks that investors
can avoid through diversification.
Random bad things happen to companies.
Random good things happen to companies.
One random good thing is that something bad
happens to your competitor.
Or maybe an ordinary product breaks out.
You sell hula hoops, which are just plastic hoops,
but in 1958 and 1959 in the United States,
all of a sudden, everybody decided they needed a hula hoop
and 100 million of them were sold.
Maybe your company product developers
stumble on a chance discovery, such as penicillin,
velcro, or post-it notes.
These were all random good discoveries.
Random events that couldn't have been predicted.
So, random bad things happen to companies,
and random good things happen to companies.
That's extra risk, but you're not going to be paid
for bearing that risk because that risk can be eliminated
or at least reduced through diversification.
Key points.
I am risk averse.
If you want me to bear risk,
you're going to have to pay me extra.
Diversification reduces risk,
so I don't get paid for bearing risk
that can be reduced or eliminated through diversification.