Correlated Risk: Diversification is a Lie

Risk in the financial markets can be misconstrued, and/or skewed due to a couple of reasons including diversification risk. All investment advice says to diversify in order to minimize risk. This, however, does not get rid of all the risk. This is due to the correlated risk in the markets. Like a house of cards, the markets will all fall flat at the same time triggered by a catalyst.

What is Correlated Risk?

Correlated risk is risk that entails high correlation of markets as well as the degree to which different markets are interconnected. The higher the correlation there is in different markets the greater chance there is for systemic market failure. This risk measure can be gauged by the actual correlation between different global markets. Although, most of the time, systemic market failure can not be accurately predicted because all the market failure happens all at once.

For instance, during the 2008 U.S. subprime "meltdown", many high performing hedge funds had simply been obliterated. Investors who had acquired bonds that used sub-prime mortgages as their collateral had seen their investments simply blow up because of the credit "meltdown". Credit had been so artificially secured that many people had FICO scores that were well above the average in history.

All in all, investments such as mortgage bonds had been artificially inflated in price because of the lack of oversight to measure the true risk of these hybrid derivative instruments. After these investments no longer could stay solvent, investors had lost all their capital and a systemic credit failure overall in the U.S. had ensued due to lack of bank oversight and regulation in their massively leveraged risk taking. Well, this ended up triggering systemic market failure across the global in all markets because of the correlated risk that had already been exhibited statistically in the equity markets.

How to Hedge your Risk

Since diversifying your investment portfolio with different stocks cannot save you from systemic market failure you have to know how to hedge your bets. Essentially, markets that are negatively correlated and are fundamentally counteracting each other are the best markets to balance an entire investment portfolio. It's simply not cautious enough to diversify in negatively correlated assets in the same market, because fundamentally they will eventually be led by the greater market direction when all is said and done. That's why different markets all together are what's needed. Not just that, but diversify in different investment products as well as different investment styles.

For example, you may own a mutual fund and some stocks. The only way to outlay this market risk is to invest a portion in bonds and cash as well as perhaps futures markets. When investing in derivatives it is important to always hedge your risk with products that are fundamentally counteracting each other in order to balance the risk and keep from losing nearly all your capital during market calamity. There are finer methods of money management, however, balanced risk is the most important concept of all.

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