What Merchant of Venice teaches you about diversification

Image from a production of The Merchant of Venice © Alamy
Dominic Mafham played Antonio at the Globe Theatre in 2015

The Merchant of Venice has divided critics, with some seeing it as a veiled attack on anti-Semitic attitudes, while others see it as endorsing them. The Venetian nobleman Bassanio has fallen in love with Portia. In order to get enough money to woo her, he persuades his merchant friend Antonio to borrow money from the money-lender Shylock on his behalf. However, when Antonio’s ships are apparently wrecked, Shylock demands to take the “pound of flesh” that he was promised as security, by cutting out Antonio’s heart.

The key moment

At the start of the play, Antonio (pictured, played by Dominic Mafham in a performance at the Globe Theatre in 2015) declares that he is sad. His friends Salarino and Solanio suggest that it is due to his business concerns as “had I such venture forth / The better part of my affections would / Be with my hopes abroad”. But Antonio insists that he is not concerned about his business because “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.”

The lesson for investors

Diversification, or the idea of splitting your portfolio between several assets that are less than perfectly correlated, is a good way to reduce your risk without (theoretically) reducing your returns. Perhaps the most famous illustration of this was a 1977 study by EJ Elton and MJ Gruber, which investigated how varying the size of your portfolio affected risk. It found that while a single share had a standard deviation of annual returns of 49.2%, adding just one share to your stock portfolio cut theat by nearly a quarter to 37.4%.

Other financial wisdom

In Act Two, we find out from Shylock that in reality Antonio has only four ships (“an argosy bound to Tripolis, another to the Indies; a third at Mexico, a fourth for England”). So it should come as no surprise that Bassanio receives a letter from Antonio telling him that “my ships have all miscarried, my creditors grow cruel, my estate is very low”. While a portfolio that holds four stocks is much less risky than a single stock, it is still too few to reduce risks effectively. Studies have found that you need at least a ten-stock portfolio to eliminate most non-market risks, with little added benefit once you get beyond 30 stocks.