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Diversify to Manage Risk: a Lesson from Medieval Peruvian Farmers

March 4th, 2011 · 6 Comments · Off-track

I recently came across the story of how ancient Peruvian farmers used the concept of diversification in order to reduce their risks. I liked the comparison to trading diversification and I thought it would be a good subject for a quick “Friday post”.

I was pointed to this story by a new interesting systematic trading blog: STROM Macro, set up by Ström, a reader of this blog – thanks for the pointer.

The story is part of the foreword by Jared Diamond to the book The Invisible Hands: Top Hedge Fund Traders on Bubbles, Crashes, and Real Money.
The book “focuses on the mistakes made and lessons learned in the financial crisis of 2008” and contains interviews with managers who “survived and prospered through the financial crisis” discussing “new paradigm of risk management and profit making opportunities in the post-crisis world”.

Investment Managers and Peruvian Farmers: Similar Goals

In the foreword, Diamond draws a parallel between investment managers and Peruvian farmers in the way they have to manage their risks.

The farming story explains how ancient Peruvian peasants adopted a seemingly puzzling cultivation strategy: instead of growing crops on a large plot of land, they used to cultivate several smaller strips scattered around where they lived. This was of course less convenient to manage, and also reduced overall crop yield (compared to a single large plot), but this “diversification strategy” ensured the peasants a lower risk of starvation, if one of their plot failed (due to rats, thiefs, climate). Since potatoes cannot be saved from one year to the next, planting one large plot only would be the equivalent of “betting the ranch” on that one big trade: one failure, and you’re out of the game.

What is interesting is the unaware sophistication of the Peruvian farmers “diversification strategy”, as studied by an anthropologist. Obviously, an increasing number of strips cultivated had a negative impact on the average potato harvest, but also had a positive impact on the potato harvest variance, by lowering it (i.e. more diversification means lower return potential but with less variability). After-the-facts calculation by anthropologists showed that peasants used to plant just 2 or 3 strips over the theoretical target required to achieve a zero-frequency of starvation years (when total harvest was not high enough to sustain the farmers).

As Diamond concludes:

Peasants do not aim at maximizing long-term averaged yield, instead they only maximize long-term yield insofar as that is consistent with their overriding goal of eliminating their risk of starving in any given year, and throwing in a small safety margin for that calculation.

In the same way, trading is, before all else, a survival game.

The above is a quick summary but you can read most of the foreword in the “Look inside” view on the book Amazon page). I have not read the book itself but it seems to have been reviewed positively.

I have read a few books from Jared Diamond and really enjoyed them and found them interesting. A good one to start with is the most famous Guns, Germs and Steel, which has also been turned into a great National Geographic documentary.

Enjoy your weekend!

Picture credits: oxfam via flickr (CC)
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