Portfolio Diversification is a critical consideration when managing the risk of a portfolio of trading strategies.
If you’ve watched the previous introduction to trading diversification video you’ll know how important it is.
However, it isn’t the only consideration 💡
We’re going to discuss some things to be aware of when looking into risk management techniques.
Here are two considerations where diversification might not work as well as one would hope:
1) Black Swans
It’s okay, you don’t need protection from Natalie Portman. A black swan is an “unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences”.
Can you think of an example of a black swan?
Tag us on Twitter (@Darwinexchange) with your thoughts, and if you’ve been the victim of a black swan event?
During these events, previously uncorrelated assets tend to become correlated due to unforeseen circumstances. This can reduce the effectiveness of this method of risk management.
2) Market Randomness
Regardless of how correlated two assets are. There will be times when both move in the same direction.
This temporary correlation doesn’t mean the same forces are driving them.
Due to the sheer quantity of assets and the nature of the financial markets, there will be a level of randomness to the price action. Thus reducing the effectiveness of portfolio diversification.
Ultimately, knowledge is power. By understanding areas where diversification may not be as effective, we can take steps to mitigate these risks. Reducing the risk on your portfolio is a multi-stage process.
Portfolio diversification is important, but it is only one aspect.
Hopefully, by the end of this series, you’ll feel comfortable implementing these valuable insights into your own portfolio.
If we diversify our portfolio across 4 uncorrelated assets, using the figures Martyn gives in the video, fill in the blank:
Diversification can only contribute to reducing the risk a max of __________% of the time.
Answers in the comments below!
The issues discussed here are just some of many that need to be considered when measuring risk.
Video Series: Why & How We Measure Risk differently at Darwinex
Watch the full playlist on YouTube here
Here’s video #1 where we describe the differences between Money Management and Risk.
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Content Disclaimer: The contents of this video (and all other videos by the presenter) are for educational purposes only, and are not to be construed as financial and/or investment advice.