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Suppose you have worked hard, saved, and now have a nice nest egg. How should you invest your accumulated wealth? The old adage, "Don't put all your eggs in one basket," gives some helpful advice, but it does not take you very far. How do you decide what investment strategy is best for you? How many baskets should you have, and which ones should you choose? Modern investment theories provide sophisticated answers to these questions. In a National Forum issue devoted to "Origins," one might ask: What are the origins of these theories, and what advice do they offer?
Rudimentary antecedents of modern investment theory may be found in works a century ago, and Nobel economist John Hicks identified the basic concepts in the 1930s. Yet most agree that the true origins date from the 1950s and 1960s. Two economists who can lay reasonable claim to originating the theory, although numerous others contributed, are recent Nobel prize winners Harry Markowitz and William F. Sharpe. In the late 1950s, Markowitz clarified the "basket of eggs" issue with his insight into the nature and benefits of diversification. Shortly afterward, Sharpe elucidated the relationship between risk and return in a widely accepted capital market theory which shows that higher returns may be achieved only by taking more risk. Taking risk means that the investor may suffer a loss.
Diversification Is Important
Markowitz's powerful insight lay in the way diversification -- putting your eggs in different baskets -- reduces investment risk. Suppose you live on a mythical island where a bountiful nature provides almost everything you could ask for. Its only shortcoming is the rainy season, which lasts exactly half of each year in an otherwise ideal climate. Two of the island's three industries exist because of the rainy season: umbrellas and housing. Both flourish at the beginning of the rainy season but languish once the sun returns. The third industry, bikinis, flourishes as new fashions are introduced at the beginning of the sunny season, but sales and profits disappear with the coming of the rains. If the...