Welcome back. Today we are going to talk about limits of diversification, and a good understanding of the limits of diversification will serve as an incentive for us to look beyond diversification, to talk a little bit about hedging and eventually, to move into insurance, which is extremely useful form of risk management. Okay, first of all, we know what the benefits of diversification are all about. Diversification allows you to most efficiently harvest this premium by eliminating unrewarded risks, specific risks in investors portfolios. By squeezing out everything that's unrewarded from your portfolio, you get a portfolio that does a good job at generating the highest possible reward per unit of risk, which is good. Nobody should be holding unrewarded risk. It's okay to hold risk. If risk is rewarded, its plan useless to hold unrewarded. There is good in their works. Well, that works on average across market conditions, but that doesn't work when you need it the most, which is a well-documented limit of diversification. So in other words, if you think about a severe bear market situation, let's think about, for example, 2008. Well, even well diversified equity portfolio will lose a lot of value in 2008. All right? Think about it this way, there was a contagion or stocks are going down. They are going down in value big time, maybe 15 percent down, 20 percent down. Given that they're all going down, there's not much that you can do for diversification. So whether you're holding a single stock portfolio or portfolio well-diversified across many stocks, they're all going down by 20 percent. Your portfolio is going down by 20 percent. In other words, almost by definition diversification cannot help you deal with systematic risk. So by systematic risk I mean the risk factor that impacts all the assets simultaneously. Okay, you cannot diversify away systematic risk, you can only diversify with specific risk or idiosyncratic risk as we call it. What should you do then? Well you should go and turn to hedging as we've seen when discussing liberty hedging portfolios because if there's a massive systematic risk factor such as decreases in interest rate, that leads to an increase in liabilities. Well, if part of your portfolio has the exact same risk exposure as your liabilities. In other words, if you're holding duration matching liberty hedging portfolios while the impact would be exactly the same on the liability side and on the asset side at least for that fraction of your portfolio. So you're funding ratio will not suffer too much. Now the problem with hedging of course is hedging is purely symmetric. You're getting protection on the downside but at the same time you're giving up on the upside. So hedging is okay but it's only okay for wealthy investors. So in other words, if you're funding ratio is currently at 100 percent, you're extremely wealthy and you can secure all of your liabilities or all of your goals if you're an individual with your current contribution, you don't need upside. Well yes, then hedging is super-useful. You should hedge everything so that your securing 100 percent funding ratio but that's really expensive. Most asset owners, they need some access to upside performance to alleviate if you will, the cost or the need for additional contribution. Well, that's precisely where insurance come along handy. One way to think about it is when you're facing the dilemma in terms of how much should they put at risk and bring to the market in terms of eggs, how much do I allocate to performance seeking assets in other worlds, and how much should I keep safe home. Meaning how much should I invest in liability hedging assets. That question is very tricky if you think about it in a static setting, because if you allocate very little to the performance seeking portfolio, in most market conditions and across many scenarios, you're not going to enjoy the upside potential that you need. So that's not good. On the other hand, if you allocate lots to risky assets in those few scenarios when things go wrong, you all going to be wasted. You're going to go bankrupt. You're not going to be able to meet those liability payments. It turns out that the best way to deal with this situation is actually to implement dynamic hedging. So that's exactly what insurance is. Insurance gives you the best of both worlds. It's going to give you downside protection but you still going to enjoy a fair amount of upside potential, and the best of both worlds can be achieved by dynamic hedging. So let me give you a very simple example or illustration to think about what dynamic hedging means, and then eventually next time we're going to look at actual implementation of the technique. Well at the conceptual level, it's just as if you're driving a car and you know that you need to go from point A to point B and that's a long distance, let's say 100 miles, and you have a limited time to do this. If you have to pick a constant speed, that's a real problem because if you pick a low speed, you're not going to make it. If you pick at 20 miles per hour, you're not going to make the 100 miles in an hour, so you're going to fall short of the target. Now, if you're thinking differently and say, I need to go at least 100 miles an hour to cover the 100 miles in an hour. While the problem though is that if you go 100 miles an hour, that's okay if the road is all straight but as soon as you have to take turns and potentially sharp turns, well then you know that something bad is going to happen. You're going to crash and you're going to lose control of the vehicle. So picking the right speed gives you like a dead-end type situation. If you go too slow, you're not going to make it. If you go too faster you're going to die. So what's the situation out of that problem? Well we know what the situation is. The solution out of this problem is very simple; you should start and go fast and potentially higher than 100 miles per hour as long as the road is straight, nice and easy, and whenever you're getting close to a sharp turn, then you should slow down and whenever you maneuver through those sharp turn then you should go back fast. If things go okay and if there's no only sharp turns but fair amounts of straight roads just like fair amount of decent market conditions, then you're going to be able to make it and reach your goal in the dedicated allocated amount of time. Well that's exactly the same. So next time, we're going to talk about how we can adjust risk-taking as a function of the margin for error, and when the margin for error disappears we should slow down, while the margin for error is big we should speed up in terms of risk-taking. Wrap up for today; insurance is a nice compliment to diversification, and hedging insurance is going to build on diversification and hedging, and insurance will tell you that the best way to think about how much to optimally allocate the risky performance seeking portfolio and to the safe liability hedging portfolio to the actually be not constant, not static but should vary over time as a function of how well you're doing and how much risk budget there is to spend. This is exactly what we are going to discuss next time.
