Diversification and Freedom

by Michael S. Rozeff
by Michael S. Rozeff

I present a new argument as to why a free society (anarchy or self-government) is better than a State-controlled society. The argument builds upon a diversification effect that Phil O’Connor and I have explained in several finance articles.

In a free society, every individual pursues his or her own happiness without forcibly controlling other people’s lives or being controlled by others. This process tends to diversify the economy. By contrast, the State replaces individual freedom with central control over resources. This encourages rulers to place big bets that undiversify the economy.

Diversification via independent individual behavior reduces the chances of everyone experiencing both extreme gains and losses when outcomes are uncertain, and it creates more conditions of gain outweighing loss. These beneficial outcomes happen automatically and without central direction when individuals pursue their own interests rather than amalgamating them under a State. The net result turns out to be an increase in overall gains compared to overall losses.

This is an argument that holds other factors constant, in particular, the risks and opportunities to invest. The benefits of freedom for innovation and for assessing future risks are a separate argument not considered here.

Although the argument has a social side to it, it is not utilitarian. This is because diversification provides a free lunch. No aggregation of individual utility or happiness is necessary to get the benefit.

Freedom, as the esteemed condition that opposes bondage, cannot be understood and defended enough. The diversification argument is strong enough to be counted in freedom’s defense. We will see toward the end that it applies well to real world situations.

Intuitively, if all of us follow Adolph’s orders, we are placing many of our eggs in one basket. He mobilizes the country for one big project – war. We might end up rulers of the world and very well off, or we might end up dead or destitute in short order. If instead we each follow our own way independently, the chance of all of us ending up world rulers is reduced, but so is the chance that we all end up dead. Some of us will do better than others and some worse. However, the aggregate of us under freedom will turn out to experience a higher ratio of gains to losses than if we had all followed Adolph.

Human beings naturally diversify when they are unsure of the future, and this helps them survive. For example, suppose a hurricane hits a tropical island and no one is sure how to face it. Some leave hurriedly in canoes and boats. Some take shelter in a sturdy building on high ground. Others select various trees and climb them. Some lash themselves down. Some methods will fail and some succeed. The diversification may not save everyone, but some are more likely to survive. Looked at this way, diversification is somewhat akin to trial and error. If enough people try different ways of doing things, perhaps a few will discover a better way. Even if a better method is found, people in the future will still diversify and try other methods. Freedom fosters new tries.

To see how diversification works requires a model. It is a very simple model that most people understand intuitively and can grasp when numbers are put into it. Suppose that we are living under Fidel and we give him our resources to command. Their worth is $50. He or we can always place them in a Swiss bank and get $55 for us. That is the perfectly safe thing to do, and we measure gains and losses from that $55 that he and we can always secure. Anything above $55 is a gain and anything below $55 is a loss.

There are many plantations that both we and Fidel can invest in, and they all pay off either $30 or $90. They produce crops like sugar, tea, coffee, tobacco, bananas, nutmeg, rubber, etc. These are activities that can turn out well or badly, like most things in life. I assume for simplicity that how each type of crop pays off is independent of how every other crop pays off. This is more realistic than it seems because the world prices of many items are influenced by conditions in far-flung places. Even if our country experiences the same weather everywhere and all our different crops face that weather, they bear up under it unequally; but more importantly, the prices we can get for different crops depends on weather conditions all over the world. If there is not complete independence of crop payoffs, the argument still goes through as long as the crop payoffs are not perfectly synchronized.

Imagine that a big country-wide sugar plantation can produce either $30 or $90 worth of sugar for all of us. There’s a fifty-fifty chance of either outcome. In the loss state, we have a loss of $25 because $55 – $30 = $25. In the gain state, we have a gain of $35 because $90 – $55 = $35.

If Fidel has our $50, he gambles on a big country-wide investment, say it is sugar, and we either win or lose. Our expected gain is 0.5 x $35 = $17.50 and our expected loss is 0.5 x $25 = $12.50. The ratio of expected gain to expected loss is 17.50/12.50 = 1.4. We are happy that he spent $50 on sugar rather than statues of himself. But we now shall see that we would be happier still if we did something else.

Another option we have as individuals is to divide the country into two provinces, each with its own Fidel, F1 and F2. They each act independently. Each now has $25, and each selects a crop. If each chooses the same crop, sugar or tea or whatever, then we are no better or worse off than we were under Fidel. Suppose instead that F1 selects sugar and F2 selects tea. Both investments have the same payoff pattern, but each dictator can only control half a plantation. There are now 4 possible outcomes as follows:

Each outcome has a 0.25 chance of happening. This is just like flipping two coins that can come up heads or tails. Outcome 1 is two tails, or each part of the country gets 30. Outcome 2 is that F1 gets a loss (30) and F2 gets a gain (90), like a tail and a head. Outcome 3 is just the opposite of outcome 2, like a head and a tail. Outcome 4 is like two heads; both F1 and F2 get 90.

Now find the gains and losses for the whole country. Outcome 1 brings $30 to the country, and the loss is $55 – $30 = $25. The second outcome results in half getting $30 and half getting $90, for a total of $60, which is 0.5(30 + 90). This provides the country with a gain of $5, which is $60 – $55. The third outcome also gives a gain of $5. The fourth outcome gives a gain of $35 = $90 – $55.

The four things that can happen to the country under F1 and F2 are a loss of $25 and gains of $5, $5, or $35. The chance of each outcome is 0.25. The expected gain is 0.25($5) + 0.25($5) + 0.25($35) = $11.25. The expected loss is 0.25($25) = $6.25.

With two provinces, the ratio of expected gain to expected loss is 11.25/6.25 = 1.8. This is higher than the 1.4 the country got under just Fidel alone. That is because the country diversified over two kinds of crops.

If expected gains are desired and expected losses are not desired, then the country as a whole is better off by dividing itself into two provinces with two regional chiefs, F1 and F2, and two half-plantations. One benefit is that in outcomes 2 and 3, the lucky region can transfer some of its excess to the unluckier region. They may make a deal to do this. This smooths out their income, so that they do not have to suffer when income is only 30. Another benefit is that outcome 1 now occurs only 1 time in 4 instead of half the time. This is counterbalanced somewhat by being flush with 90 only 1 time in 4 instead of half the time. However, as I shall argue, most people value the avoidance of a big loss more than the acceptance of an equal-sized gain.

Why not subdivide even further? Why not, indeed. With 3 regions, society’s expected gain loss ratio rises to 2. With 5 leaders, it rises to 2.6. With 30 regions, it rises to 10.2. In fact, the ratio of expected gain to expected loss rises indefinitely as the country divides itself further and further. Eventually, we get down to individuals, each with his own small plantation.

Although each person does not have a plantation that is any better than anyone else’s, they do not all suffer depression or enjoy boom together because they are growing different crops. Their overall economy is diversified. If there is a run of bad years for one type of crop, there will usually be others that are doing well.

Diversification is good. The people doing well can lend to the people doing badly, or they can make them gifts. Perhaps they can hire them to work on some other projects altogether. The diversified economy is less likely to experience bankruptcy, or a situation where everyone is defaulting on their loans. It is less likely to have to store crops against 7 years of famine as Joseph advised the Egyptians to do. This is costly. The crops rot and are attacked by insects. They are not in a productive form. If the economy is diversified, the people are less likely to become nomads or migrate to other lands in search of opportunities. These activities are costly too. If the economy is diversified, the people are less likely to attack other peoples or to borrow from them in order to survive.

Even though every person faces exactly the same outcomes, either a gain of $35 or a loss of $25 (that can be subdivided), if each person chooses a plantation type independently of what the other fellow chooses, the society’s ratio of expected gain to expected loss rises.

The argument that society is better off under freedom can be strengthened if we analyze the preferences of individuals regarding gains and losses. This amounts to saying something about how people view risk.

Under Fidel alone, the expected gain is $17.50 and the expected loss is $12.50. With F1 and F2, they are $11.25 and $6.25. Expected gain is reduced by $6.25 and so is expected loss. (Equal reductions of lesser amount keep on happening as we keep on subdividing the investment.) If people are risk averse, it means that they dislike a loss of $1 more than they like a gain of a $1. If they are risk averse, then reducing both the expected gains and losses by the same amount makes them better off. Then F1 and F2 are preferable to just Fidel alone.

The diversification argument for freedom is aided by the presence of risk aversion. With Fidel alone there is a 50% chance of a loss of $25. With 3 Fidels, there is only a 12.5% chance of a $25 loss, and 87.5% chance of a gain ranging from 5 to 15 to 35. True, the chance of the big gain is less, but society is far more sure of having a gain and no loss. There is only 1 chance in 8 of having a big depression. All 7 of the other outcomes have gains.

Are you risk averse or not? If you buy insurance, then you are showing risk aversion. If you invest all your wealth in one stock, then you are not showing risk aversion. If you have a portfolio of stocks, then you are showing risk aversion. If you slow down when you see a patrol car, then you are showing risk aversion. If you look both ways before crossing the street, then you are showing risk aversion. If you bet your annual salary on a turn of the roulette wheel, then you are not showing risk aversion.

Suppose you are offered a double or nothing investment that costs $100,000. After you pay me this money, I flip a fair coin. If it comes up heads, I give you $200,000. If it comes up tails, you get $0 (and I keep the $100,000). This means that you profit by $100,000 with heads and you lose $100,000 with tails with a 50-50 chance of each occurrence. At what chance of the gain will you buy into this investment? Will you invest if the chance of heads is 0.1 or 0.2, or 0.5, or 0.6, or 0.7, or what? If you refuse to take this gamble when the chance of the gain is 0.5 or lower, then you are showing risk-aversion.

Given the vast amounts of insurance that are purchased, we can be quite sure that most people are averse to risk. This implies that when significant amounts of wealth are involved, they fear losses more than they regret not getting gains of the same amount.

Because risk aversion is real, those who diversify their bets are better off than by amassing all their wealth into one pile and making one big bet. Exercising individual freedom includes, among other benefits, the process of diversification. It happens naturally. There are few free lunches in this world, but diversification is one of them.

When risk averse individuals are ruled by a small clique with the power to take their wealth and bet with it, even if those in power are constrained to bet on equally good investments that the people can bet on except on a bigger scale, the people will get more risk of loss without getting back enough chance of gain to compensate for the loss. They will end up worse off. If everyone in society makes their own bets, they will discover that the diversification effect makes them better off as a group.

We can complicate this simple picture in many ways, but the basic insight will not change. If there are economies of scale and people voluntarily aggregate their enterprises into larger plantations, that means that diversification is traded off against size. This, of course, is not how States have come about. If the rulers do not select plantations but instead build pyramids, tanks, or Mars rockets or items that individuals do not value, then the societal outcome is far worse. If the plantations or other opportunities are actually not "given" but are created by individuals, this augments the case for freedom in an important way. It doesn’t undermine the diversification benefit. If the opportunities do not all have the same payoffs as these plantations do, the argument still holds although the numbers change. If the opportunities are not all independent, the gain to loss ratio will still rise, although more slowly.

Another complicating factor is knowledge. If some individuals know more or are thought to know more than others about opportunities, then they may be able to attract more money and make bigger bets. This undiversifies an economy in favor of the projects thought to be better. This factor also does not negate the diversification effect. It means that people are trading off a safer diversified situation for one perceived to give a higher ratio of gain to loss because the project is thought to be so good. Free individuals in free societies certainly make these choices. On the other hand, if the State forcibly collects capital to invest in what the rulers think is good, their lack of knowledge about opportunities is likely to give up diversification for no tangible benefit.

The diversification factor applies to the real world of States. Consider the country Malawi. There are other countries in the world like this in which "Land tenure is skewed, with a limited number of large estates controlling a substantial proportion of the arable acreage. About 100 large white-owned farms remain as holdovers of the British colonial era. Other big estates are owned by relatives of the late President Banda and prominent officials." The landlords place big bets on a few cash crops such as tea and tobacco. "The undiversified economy, dependent on world prices of a few commodities and variable crop-growing conditions, is subject to volatile swings." For the owners, the instability of these commodity prices can be counteracted in a variety of ways. For the poor people working the land, they cannot. These poor tenant farmers become virtual bonded laborers.

Fidel Castro mortgaged his country to the Soviet Union by pledging sugar for various items including arms. This policy, if anything, made the Cuban economy even more undiversified. He heavily exposed the poor to the vagaries of world sugar prices. When sugar prices fell, they suffered. The Soviet Union marshaled and centralized a huge fraction of its empire’s wealth so that it could invest heavily in selected enterprises such as heavy industry. It sought to diversify away from agriculture. It failed. In terms of diversification, Russia’s leaders reduced the gain/loss ratio of the society and made people worse off. We can find many more undiversified economies located in Africa, South America, the Middle East, the Pacific, and Asia. We can also find numerous regions and cities of the United States that claim to be engaged in economic development but which are really involved in projects that line the pockets of special interest groups. Many of these big and splashy projects undiversify the local economy.

I repeat. There are many countries in bad straits that have been or are now subjected to a Fidel or a Stalin, a colonialist or imperialist, a set of feudal landlords, oligarchs, tyrants, parliaments, legislatures, or development planners. Powerful men select a few projects or directions that they favor. They never replicate what a society of free men would invest in. Otherwise, of what use is power? Powerful men use everything and everyone that they can possibly control for their own aims. Being the aims of a single man or a few men, they are far more restricted and undiversified as compared with those of the very many individuals under their rule.

There are many countries subject to heavy State restrictions. There are many that are affected negatively by what major powers like the U.S. do. There are yet other countries where people are tied to volatile cash crops because their opportunities are poor, again for a variety of reasons. All of these situations that restrict diversification add to and foster other problems that people may have of ignorance, culture, and health.

Throwing money at such conditions is worse than useless. It’s harmful. To whom is the World Bank accountable? Which of us knows what the World Bank is doing with our money? The World Bank admits that "many past assistance efforts, including some of its own, failed because the agenda was driven by donors rather than by the governments it was trying to assist..." In other words, the U.S. and other donor States used loans for their own aims, not those of recipients. Often countries like the U.S. make matters worse by dumping agricultural surpluses overseas or imposing trade quotas and tariffs that hamper imports or, conversely, subsidize U.S. exports. What kind of help is that?

Now the World Bank has shifted to a new model. "Under its current development policy, the Bank helps governments take the lead in preparing and implementing development strategies..." This strategy will fail miserably because it is still State planning with a twist in which a clan of experts sporting university degrees attempts to guide development, thereby substituting themselves at taxpayer expense for the colonialists of old.

A great many countries have many, many inter-related problems that are as thorny as those that our own country faces. But most such countries are very much poorer than the U.S. in various ways or face other obstacles. The lack of diversification in the economies of these countries signals deeper underlying causes of many, many kinds. Lack of freedom is surely one of these causes.

My main point is that freedom leads to a society-wide diversification benefit. Freedom and a diversified economy tend to go hand in hand, although the connection is by no means necessary. Diversification is desirable. When natural circumstances prevent diversification, free people seek ways to insure and diversify by other means such as storage, migration or becoming nomads. By contrast, centralized State planning and/or dictatorial control of a country’s resources, wholly or partly, is disastrous because it typically reduces diversification. Centralization, among its other evils, raises the prospect of losses from production not balanced against compensating gains. States that control production tend to focus resources on a few enterprises, and this perversely lowers the society’s ratio of expected gain to expected loss.

October 13, 2005

Michael S. Rozeff [send him mail] is the Louis M. Jacobs Professor of Finance at University at Buffalo.

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