When Fred retrieves the number 2 from an information system and Joe retrieves the number 3, their results are *modular* (as in modular furniture) in that they can be consolidated. Just add them together, as in 2 + 3 = 5. But if Fred retrieves the distribution of petroleum prices and Joe retrieves the distribution of an airline stock, how do we consolidate these into a portfolio? Recall from the ladder analogy of Chapter 3 that the simulation of the sum is *not* the sum of the simulations.

In general, probability distributions don’t add up like numbers for two reasons. First, there is the diversification effect described in terms of the movie portfolios; that is, the sum of two dice or spinners goes up in the middle. Second, there are the interrelationships to worry about, as discussed in terms of the investment examples. When petroleum prices go up, airline stocks tend to go down.

When Markowitz added the distributions of a set of stocks to get the distribution ...

Start Free Trial

No credit card required