Asset and investment managers have good reasons to say that diversification – reducing risk without affecting returns – is their top priority. Sure, they talk about risk, correlation and efficiency, but we can imagine their job as being a Michelin-starred chef or a Premier League football manager: always on the clock and combining their assets the best possible way.
Indeed, what sets them apart from their amateur counterparts is not only their superior knowledge but their ability to dynamically adapt and master the right tools to constantly deliver a high-quality performance. As we are going to see, the same applies when we build efficient and well-diversified portfolios. Professionals that aim to achieve long-term and effective diversification, not only know the basics of risk and correlations but are also using AI to better understand their inner dynamics and get an edge. They are moving towards a new approach to portfolio management, taking portfolio construction one step further: a forward-looking approach to diversification to successfully navigate the complexity of financial markets.
If we were to explain diversification to our children, we could tell them that having a few different toys to play with is better than just having one. Indeed, even if one broke, they would still be able to play with the remaining ones. To a certain extent, this is what happens when we invest in financial markets, where instead of toys, we have securities like stocks, bonds and derivatives to “play” with. Yet, the same concept holds true: we have to diversify our investments, that is, mitigating the risks of them not delivering the positive performance we expect.