The Ancients were not known to be entirely investor-savvy people. The great Aristotle believed it was unnatural for money to breed money and thus condemned investing. There are always exceptions, however.
Take Marcus Porcius Cato the Elder, for example. Imagine that you’ve just returned from Spain after a successful campaign and have captured quite a bit of local silver. What could you possibly do with all that money? Well, Cato had an answer.
Invest and Diversify
Investing wasn’t so easy, though. No banks. No corporations. No bonds. No registered investment advisors. So what did Cato do? He bought boats… ,well, parts of boats. Here’s what the ancient biographer Plutarch wrote regarding Cato:
“He used to loan money also in the most disreputable of all ways, namely, on ships, and his method was as follows. He required his borrowers to form a large company, and when there were fifty partners and as many ships for his security, he took one share in the company himself, and was represented by Quintio, a freedman of his, who accompanied his clients in all their ventures. In this way his entire security was not imperiled, but only a small part of it, and his profits were large.”
While Plutarch still believed investing was disreputable, we have a clear example of an early form of diversification, or trying to invest in different assets so that your risk is minimized. Let’s look more closely at what Cato the Elder did:
- He ensured that all of his borrowers, or investees, formed one large “corporation” in a sense. By pooling their resources, he ensured that not only he, but all the others spread the risk by having everyone be part of the same pool.
- He made certain that his slave, Quintio, acted as a representative to ascertain the correct amount of pay that Cato deserved. But on the other hand, Quintio may have been there to make sure the “clients” played it smart, and did not drop anchor in a tiny strait when a storm was coming.
- By a portion of a “corporation” with multiple ships, he reduced his risk exposure as compared with the risk of owning only one ship.
Now let’s roll back to this century. Cato would put on his reading glasses, open up his TD Ameritrade or E-trade account and split his money between bonds and equities, like we’ve all been told countless times. So what’s the point? We all know that.
Uncorrelated Assets
Let’s imagine that we know more details about Cato’s ships. Say that Cato, Inc. has three ships. All three carry wine from Spain to Rome, and Spanish wine is really hip back in Rome, so Cato’s making a nice side business.
Now the Spanish, who disliked Romans very intensely, decide that they still prefer beer to wine and are tired of making wine for the Romans , so they decide to trample all the vineyards and grow beer. Spanish wine isn’t such a great business to be in, anymore. Cato Inc. is out of business.
What happened? Cato diversified, true. He bought different ships, spread his wealth, and tried to ensure that if a pirate captured one ship, he’d have two more. Everything was dandy.
Cato had essentially put three different frogs in the same pond. He invested in what’s called correlated assets. When the pond (Spanish wines) dried up, he lost all his frogs.
Now imagine Cato, Inc. with a different structure. One ship imports wine from Spain, one imports figs from Greece, and one imports barley from Egypt. Aha… Now when Spain takes a turn for the worse, Cato is not sweating. Greek or Egyptian products may not be as hip as Spanish wine, but someone’s always eating figs and cowards in the Roman military are always fed barley, so the money flow is still there.
Same initial diversification. The only difference is Cato was investing in uncorrelated assets.
Putting It All Together
Investors, when they create portfolios, often look to make sure that when they diversify, they are investing in uncorrelated assets. While two different stocks are two different stocks, if they are dependent on the same X factor, they will both tumble at the same time. Hence, if you buy stock in X and Y and they both sell hamburgers, and the price of beef goes skyrocketing, X and Y will both take hits. The right approach is to buy both X and Z, where Z is something uncorrelated to X. But how do we identify correlated and uncorrelated assets? This involves a number of approaches: history (what did Z and X do before?), economics (if the economy slows, how will Z and X react?), statistics, and some good old intuition (do both Z and X sell Spanish wines?). In other words, diversification alone is not enough; it helps to pair diversification with research into the diversified assets.
Now you’ve taken diversification to the next level. You’ve combined it with research. Now you’re one step ahead of Cato the Elder.