Eggs and Baskets
By 1912 Giosuè Gallucci, “the King of Little Italy”, had a business in East Harlem for every occasion, Dash writes. In summer he sold ice, in winter coal. He lent money at interest, and few in the neighbourhood lent more. He owned several shoe-repair shops and traded in olive oil. He was almost the only one selling hay and feed to the stables of the district. He owned a popular bakery. And behind the sign of the New York branch of the Royal Italian Lottery he ran an illegal lottery and sold thousands of tickets in Harlem every month.
A modest man.
Look at the first two items. Ice in summer, coal in winter. A hot summer, and the ice sells out while nobody wants coal. A cold winter, and everybody buys coal while nobody buys ice. Each business on its own jumps up and down, but together they feed you steadily, all year round. Gallucci most likely never heard the word “correlation”. But he put together what every financier dreams of: two assets that move in opposite directions. Not bad for an ice man.
Eggs in Different Baskets
People have been putting their eggs in different baskets for thousands of years. In Shakespeare, the merchant Antonio in The Merchant of Venice explains to his friends why he isn’t afraid. His goods don’t sail on one ship or lie in one place, and everything he has doesn’t depend on whether this year goes well for him. A century and a half after Shakespeare, the merchants of Amsterdam and London were already insuring cargoes in parts, with different underwriters, and putting money into several voyages at once. They didn’t trust the sea.
It only became a science in 1952, when a young American economist, Harry Markowitz, published a paper called “Portfolio Selection”. The idea was simple and revolutionary. It doesn’t matter how risky each asset is on its own. What matters is how they behave together. Two risky assets that move in opposite directions can shake less together than one calm one. Out of all possible portfolios you can pick the ones that bring in the most for a given risk, and they lie along a curve that was named the efficient frontier. Standing below the curve is foolish: for the same risk you could get more. Thirty-eight years later Markowitz got the Nobel Prize for it.
The Risk You Can’t Hide From
But even eggs that have been spread out can all be broken at once. Gallucci showed that better than any textbook.
The whole operation rested on one man. On his name, on who his friends were in city politics, on who guarded him. You remember how it ended: in May 1915 the seventh attempt on his life succeeded. However varied his portfolio, all the assets were exposed to the same thing. The owner’s life.
Only don’t be in a hurry to put this down to fate. The owner’s death broke all of Gallucci’s baskets because they were all his. An outsider with a stake in Gallucci’s bakery, in somebody else’s coal shop across town and in a laundry with a different owner would have come through that May with a bruise. Financiers call this key-person risk and concentration risk: everything rests on one man and sits in one pair of hands. You can get away from that kind of risk. You just need different people carrying the baskets.
In general, financiers sort risks by whether you can get away from them. Some sit inside a single business and hit only that one: a bakery burns down, a debtor goes bust, an owner dies, the hay crop fails. Variety saves you here: one loss drowns among the others. Others hit every business at once, whoever owns it: war, crisis, the whole market falling. That kind of risk is called systematic, and you can’t hide from it however many baskets you keep. For carrying it, the market, if you believe the generally accepted model, pays you a little extra on average. Only on average: nobody promised that they’d pay you in particular, or pay you this year. And they don’t pay extra for just any danger. Nobody pays for a risk you can get away from. Why pay for something you can get rid of almost for free, just by spreading your eggs?
And don’t confuse systematic risk with systemic risk. They sound alike, but systemic is when the financial machine itself collapses, as in 2008. Sometimes the two coincide. But they’re different words for different things.
The Home-Basket Mistake
The most common mistake is this: keeping your eggs in the basket you carry yourself.
In 2001 the American energy company Enron collapsed. And it turned out that fifteen thousand of its employees held almost sixty-two per cent of their pension savings in Enron’s own shares. At the start of the year a share was worth more than eighty dollars, and by the end of November it had fallen to sixty-one cents. In one day people were left without a job and without a pension. There was one basket. And they were carrying it themselves.
How the Mafia dealt with this, Gambetta noticed. It pays a protector to keep a small number of clients, he writes, but he’s also tempted to take on new ones—to earn more and not depend on any one of them. Protecting a single monopolist is risky: the competitors who lose out will go to the police or to rivals. It pays better to protect groups rather than individual firms. The mafioso understood the same thing Markowitz did. One client isn’t an income, it’s a leash.
Different Baskets on the Same Cart
And now for how variety turns out to be an illusion.
In June 1980 Tommaso Buscetta came back to Palermo and saw that almost all the members of Cosa Nostra were prospering. Stefano Bontate explained: it was the heroin. The raw material was brought in by three men—Spadaro, La Mattina and Savoca—and each one jealously guarded where he got it and how he moved it. Everyone else, Buscetta said, took part in this very profitable business only with their money: they clubbed together to buy and refine it.
Anyone who put money into several shipments thought he had spread it across baskets. But all the baskets were riding on the same cart. The goods came from the same three suppliers, along the same route, to the same buyers in America, and the same police were trying to catch them. The arrests and wars began. Shipments went down all at once. We know how it ended: in the early eighties Palermo was swept by the bloodiest Mafia war in history.
Different names don’t make different risks. You bought ten shares in one industry, five flats in one city, spread your money across three banks in one country? Congratulations. You’ve got one basket with ten compartments.
The Don’s Baskets
Don Vincenzo had two businesses: the laundries and the oil. He thought of them as two baskets, and in a way he was right. In a lean year there was a strike at the port, and the oil didn’t come in. The laundries kept working. They fed everyone.
But one day I showed him that almost everything we washed and sold went to restaurants and hotels in one district. If the district emptied, both baskets would empty at once. The Don was silent for a long time. Then he said, “So I have one basket with two handles.” A year later we were washing for a private hospital and two schools on the other side of town, and, remembering an old lesson, we only took them on with payment a month in advance. They paid less than the restaurants. But they didn’t close when the tourists’ mood went sour.
The Bottom Line
Don’t keep your savings in the same basket as your job, and check that your baskets aren’t riding on the same cart. And against a disaster that hits the whole market at once, baskets won’t save you. For that one the market pays a little extra on average, but it promises nothing.