The Betfair Prof / Leighton Vaughan Williams / 17 June 2009 /

The Betfair Prof, Leighton Vaughan Williams, tells all...

"Believe me, no: I thank my fortune for it, 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." So speaks Antonio in Act 1, Scene 1 of William Shakespeare's 'The Merchant of Venice'. Compare the injunction more than a thousand years earlier, of Rabbi Isaac bar Aha, contained in the Babylonian Talmud, that "One should always divide his wealth into three parts: a third in land, a third in merchandise, and a third ready to hand".

Or more than a thousand years even further back, the rejoinder contained in chapter 11 of the Old Testament book of Ecclesiastes to "Divide your merchandise among seven ventures, eight maybe, since you do not know what disasters may occur on earth." An alternative translation is to "...divide your investments among many places, for you do not know what risks might lie ahead." I think you get the point that the principle of what we now call 'portfolio diversification' is not a new one.

So by the time Miguel Cervantes had Sancho Panza declare in 'Don Quixote' that the part of a "wise man [is] to keep himself today for tomorrow and not to venture all his eggs in one basket", the idea was well established in literature. It took another 250 years or so, however, before the theory was formalized by a 25-year-old graduate student at the University of Chicago. His name was Harry Markowitz, and his paper, published in the June 1952 issue of the 'Journal of Finance' was called, simply enough, 'Portfolio Selection.'

Essentially, Markowitz's paper was a guidebook in preparing a 'free lunch', in the sense of reducing an investor's risk without reducing expected earnings. The strategy was based around the construction of a portfolio of assets which balance out one's exposure to risk, rather than reinforcing those risks. Take, for example, a mythical economy in which there are only two investment opportunities, umbrellas and sunscreen. If the weather is sunny and dry, the investment in umbrellas will perform poorly, and the investment in sunscreen well. If the weather is wet and dull, on the other hand, the reverse applies. By diversifying your investment between the two, you are reducing the volatility (one important measure of risk) of the returns from your investment.

Markowitz's genius was extending this idea to devise a strategy for reducing risk without reducing expected returns, and making it mathematically tractable. It was to earn him a Nobel Prize in Economic Science in 1990. Markowitz was not thinking about prediction markets in 1952, but an interesting perspective on the whole concept of prediction markets is the degree to which they can provide a hedging function for pre-existing risks. For example, film studios might 'sell' (or 'lay') the success of their box-office receipts as a way of partially insuring their investment.

Similarly, a politician up for election can back his opponent as a way of insuring against a defeat at the polls, as can those likely to be adversely affected by the election of a particular candidate. And what happened to Antonio? For all his diversification, he hadn't foreseen the apparent effect that the fickle finger of fate had unleashed on his far-off merchant ships, and before he learned the truth it had almost cost him a pound of flesh. If only he could have consulted a prediction market!

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