How Diversification Reduces Risk
No investment is ever a "sure thing". You might have bought shares in a company that goes bankrupt unexpectedly, or you might have bought commodities that experience a sudden price drop due to decreased demand. The one strategy that most experts agree can mitigate such risks significantly is building a diversified portfolio.
The principle behind diversification is simple: When you invest money into an asset, the value of your investment portfolio is now dependent on how well that asset does on the market. The risk is that the asset you invested in may drop in price, lowering the value of your portfolio with it. To mitigate this, you should also invest money into another asset which is bound to do well if your first asset does poorly.
Diversification is especially important for portfolios that include assets with high volatility, as their value can rise and drop unexpectedly.
Let's take a look at an example: Imagine you bought shares in an Icelandic airline, only to find a year later that one of the country's volcanoes has started spitting large amounts of ash into the air, causing all air traffic to cease. This will also cause your portfolio to lose value, as people will start using ships to get to Iceland. Had you invested in both air and sea travel sectors, your gains in the latter might have outweighed the losses you've incurred in the air travel sector, perhaps even leaving your portfolio largely unaffected.
Keep in mind that many events may impact multiple industries in the same way. If your portfolio includes both Icelandic air and sea travel, but a global pandemic causes the entire country to shut its borders, both of your investments will lose value, as they're both in travel-related industries. This is why a sufficiently diversified portfolio should diversify along all possible lines:
- assets
- asset classes
- industries
- regions
- etc.
For example, had you invested in Icelandic air and sea travel and also bought stocks of companies offering video streaming services, you might be able to mitigate the losses from people ceasing to travel with the gains from the increased demand of the house-bound populace for entertainment products.
The Importance of Correlation
Correlation is one of the most important metrics for professional traders, as it describes to what degree specific investment vehicles are correlated. As we've seen in our example, air and sea travel may be affected by different events in different ways. Still, both of them are part of the travel industry – which means an event affecting travel, in general, will affect your investments in both. These two industries are correlated to some extent.
In other words: an effective diversification strategy should aim to build a portfolio with assets that have a very low or inverse correlation. This decreases the risk that both will be affected negatively by any one event.
How Hedge Funds Diversify Risk
If you're looking into CARL's quants, you might be asking yourself: Can I use hedge fund investments as part of my diversification strategy? And the answer is: Yes, you can! Within your overall portfolio, a hedge fund that mainly invests in a specific asset type can easily serve as a "counterweight" to another investment you might have. On the flip-side, you may wish to invest in a quant that focuses on one industry, thereby incurring risk – in this situation, it'd be prudent to invest in a hedge fund that focuses on investments that have a low correlation with the investments of the first one. Or you may invest in one of CARL's quants and outweigh its overall risk by also adding very reliable assets to your portfolio, such as investments in real estate, mutual funds, or bonds.
Though even if you only invested in CARL's quantitative hedge funds, you can still benefit from diversification, as hedge funds themselves usually employ diversification (and hedging) strategies. In fact, if you're not interested in building a diversified portfolio yourself, a sufficiently diversified quant hedge fund may be just what you need, as the fund will do what it can to diversify its investments, limiting the risk both to the firm and its investors. In this way, you could invest in our quants and benefit from the advantages of portfolio diversification without needing to actively seek out different investments to use for diversification purposes.
Can Diversification Reduce Systematic Risk?
As mentioned above, all investment inherently carries a risk. Even a significantly diversified portfolio is not entirely risk-free, as there is virtually no way to mitigate what's known as "systematic risk". This is risk that is inherent to the market itself. For example, big catastrophes, wars, financial crises, and similar events can negatively impact the entire market. In such cases, it doesn't matter if your portfolio includes entertainment products as well as shares in Icelandic travel. All aspects of the market will be impacted in the same way.
Thus, systematic risk can never be fully mitigated – it's a risk inherent in any investment.
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Diversify With CARL's Quants
In times of rising inflation and low interest rates, you want to put your money into alternative investment vehicles, as most traditional investments such as the stock market simply don't provide the gains you're looking for. But since alternative investments such as hedge funds inherently carry risk, you'll want to diversify your portfolio thoroughly. CARL's quants have a role to play there, as they provide an easy way to diversify. But even if you're just looking for a good investment in itself, our quantitative strategies use diversification and hedging techniques themselves, automatically limiting the risk they're exposed to – and, by extension, the overall risk you take as an investor. Open your CARL account today and start building your portfolio!