The Portfolio Effect, the Free Lunch and the Mess in Texas

“Once upon a time there was a great and wise king who ruled a large, prosperous country. However, a great depression ensued, and no one could determine its cause. The king, seeing that people were in distress, called in the wisest economic advisors he could find from across the kingdom. There were numerous arguments in the king’s court among these advisors, many of which contradicted one another. The king, growing impatient, demanded a short, concise textbook on economics that he could read and understand. He believed this would enable him to save the kingdom from ruin.

A year later, the advisors delivered several volumes of text, each several hundred pages long, written in a jargon he could not comprehend. The king summarily had all but one of these economics advisors executed. He then had the single remaining economist appear before him and demanded a concise message.

Highly incentivized to avoid following in the footsteps of his many colleagues, the solitary remaining economic advisors did some quick thinking, and told the king “Sire, in eight words I will reveal to you all the economic wisdom:

‘There ain’t no such thing as free lunch.’”

The above short piece appeared in the El Paso Herald Post newspaper in 1938. Speaking of Texas, the state has suffered miserably as of late due to the worst power blackout in decades. Some of the event is due to extreme risk, as this was a statewide event, which is rare. Also, Texas has a deregulated standalone power grid. That works well for the state much of the time, but in an emergency it makes it impossible to import power from neighboring states.

Another significant source of the recent problems in Texas is due to an over reliance on the idea that diversification of its power sources will reduce risk. This works fairly well when the various sources are not correlated with each other, but not so well when they are highly correlated with each other. In the last 30 years, Texas has moved away from coal as a power source and has “diversified” among natural gas, solar, and wind to generate electricity. These three resources now provide 75% of the state’s electricity while coal and nuclear power providing most of the remaining 25%. While solar and wind are renewable sources of energy, they are both negatively impacted by snow and freezing weather. Frozen wind turbines and solar panels covered in snow produce no power. Gas pipelines, as posted out by Steve Roemerman in a recent blog post, produce less power in cold weather due to lower pipeline pressure. Taken together, this means these events are correlated and also that there is a particular type of correlation called tail dependency among these events which means that extreme outcomes occur together.

The problem with this high correlation is that it means that diversification among power sources does not reduce risk, especially extreme risk. Stock tout Jim Cramer of Mad Money has called diversification the “only free lunch on Wall Street.” Diversification is sometimes referred to as a “portfolio effect” as it involves combining individual ventures into a portfolio. However, as the popular saying cited at the beginning of this blog stated, “there ain’t no such thing as a free lunch.” You cannot blindly reduce risk through diversification without an understanding of the quantitative risk, which includes analyzing the dependencies among the various power sources.

I discuss the topic of diversification and correlation, including the importance of tail dependency, in my recently published book Solving for Project Risk Management: Understanding the Critical Role of Uncertainty in Project Management. You can read Chapter 1 here for free, and order from Amazon or Barnes and Noble.