Diversify Against Volatility, Hedge Against Market Risk
The point of using ETFs instead of stocks is to minimize idiosyncratic risk, namely the risk of something going wrong with an individual company. The point of adding ETFs of different asset classes is to cover more bases, such as real estate, commodities, currencies, etc. But endogenous (or market) risk remains, and this is why we employ an absolute return strategy.
Diversification is Not Downside Protection
But every now and then, there is a crash. This is the part where even professionals have failed to distinguish between diversification and downside protection. They are not the same, and saying “diversification failed” in 2008 shows a lack of understanding that:
- Diversification amongst asset classes is a way to grind out extra returns and provides some measure of protection under “normal” market conditions.
- Hedging or going to cash (when the equity goes under a “red line”) is the defense of choice during a crash; in quant-speak, it’s when correlation goes to one.
For some background, see Rise of Cross-Asset Correlations. Thanks to member Mike for the link.
Diversification matters… but not for risk
My friend Sam sent the following paper and said, “I really liked the discussion about diversification and its presumed failure during the most recent market crash. Specifically, “diversification is designed to extract risk premia in an efficient way over long horizons, not control losses over short horizons.”
For our convenience, he even highlighted the important stuff.
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