Breaking down the Modern Portfolio Theory.

Portfolio Diversification

The stock market is a wild place. Nobody wants to see their hard-earned savings disappear in a market meltdown.

But the stock market, whether we like it or not, is one of the best places to build wealth.

Fortunately, you don’t have to invest blindly and hope for the best. Stocks markets are more predictable than casino gambling. They have prices history and trends that can be modeled. There is a part you can keep under control.

Market risk vs. unique risk

Your portfolio’s risk is made of two parts: Market risk (systematic) and Unique (unsystematic) risk.

Total risk = Market Risk + Unique Risk

  • Market risk is the possibility to experience losses due to factors that affect the overall performance of the financial markets. These are economy-wide factors such as recessions, political turmoil, or changes in interest rates.
  • On the contrary, unique risk is only specific to a certain investment vehicle or industry. For example, regulatory change, natural disaster or a product recall affecting a company are a unique risks.

When you invest in stock market, there is not much you can do about the market risk. You have to accept that you will be exposed to it.

Unique risk, however, is under your control. By properly building your portfolio, you can greatly reduce the unique risks you are exposed to. You do this with diversification.

We say the market risk is undiversifiable, while the unique risk is diversifiable.

How to diversify

The more you add securities to your portfolio, the more it will be diversified and reduce the unique risks.

You can diversify at different levels:

  • Asset classes
  • Industries
  • Locations
  • Currencies

Diversification reduces the risk when it is done with assets that have a low correlation between each other - or, even better, a negative one. A negative correlation between two securities means that when one sinks, the other tends to perform well.

Typically, stocks and bonds have a low or negative correlation which makes them interesting to combine to reduce volatility.

Another way to diversify is to make sure you own stocks from different industries. For example, in 2020, tech stocks and airline stocks have had a strong negative correlation.

Let’s do the math

How to measure the correlation between assets? How to maximize the return for a given level of risk?

Sharpen your pencil because we are about to geek out with some math and financial theory!

Mean-Variance Optimization ›