A portfolio is a combination of financial assets like stocks, bonds, cash, commodities and currencies. Portfolios may be held by individual investors and/or managed by financial professionals, hedge funds, banks and other financial institutions. They are constructed according to the investor’s risk tolerance and objectives, aiming at maximizing the expected return and minimizing the risk.
What is diversification
Diversification is a technique that reduces the exposure to risk. Investments are allocated among various areas, that react in different ways to adverse events, thus minimizing risk.
4 reasons to prioritize diversification
- Lower risk. Diversification lowers your portfolio risk. Spreading your assets makes the odds of a single event impacting negatively your whole portfolio.
- Different investment styles. Investors usually take two very common approaches: value investment and growth investment. The value approach considers the strength of a company and the real value of its stock. The growth approach instead considers the growth rate of a company and other factors that could accelerate earnings.
- Limits home country bias. In finance, “home country bias” is when an investor is attached to his domestic market and doesn’t open up to international markets. Diversification makes investors invest in international markets to lower risk during domestic economic recession.
- Provides more opportunity. Diversification brings more opportunities to investors, even if they could expose them to more risk.
Correlation measures the relationship between two securities and the degree to which they move in relation to each other. If two securities have a positive correlation, they move in the same direction. If they have a negative correlation, they move in the opposite direction. An effective way to achieve greater portfolio diversification is allocating asset classes that have a low or negative correlation to other asset classes within a portfolio, as explained by Markowitz in his Modern Portfolio Theory.
As market conditions become more stressful, correlations between asset classes are less stable and move closer to each other. After a long period of “bull market” (when prices rise and there are strong results and optimism) we usually experience a period of “bear market” (when prices fall and pessimism spikes), during which the competition for “alpha” will be more intense.
Another important thing is also to diversify among different asset classes, such as bonds and stocks. Their reaction to adverse events is different and combining them following the principle of diversification will reduce your portfolio’s sensitivity to market swings. Another thing that will balance negative and positive results is diversification across bond and equity, whose markets generally move in different directions.
That is why the more the asset classes are unrelated to market swings the better.
An asset class 99% uncorrelated from finance
Only a few people realised that sports betting is a prediction market exactly as finance: in fact, in both cases, the difference between making profits or losses is the ability to estimate the correct buying price, especially if you apply the value investing strategy. Through Artificial Intelligence algorithms, it’s possible to do a fundamental quantitative analysis and use the same methods and strategies used in finance.
Sports betting remains one of the few asset classes truly unrelated to the economy since there is no relationship between global politics and economic events and the outcome of a football match.