Overview
For firms (or individuals) who cannot simply accept the risk in their portfolio, but has some need to manage the risk and possibly to reduce the risk, there are three common strategies available.
- Diversification
: the landmark
work of Harry Markowitz first elaborated mathematically the role of diversification in portfolio
construction (using portfolio variance). In some sense, it can said that diversification is the point of investing
in a portfolio of assets, as opposed to a single large asset (such as a house).
In general, diversification reduces risk, but exactly how it does that and by how much depends on the measure of risk used. The effects of diversification on portfolio returns or value is a harder question, especially within the context of multiple trading periods. - Hedging - is the process of buying or trading assets in such a way as to create a negative correlation with assets in your portfolio, thereby effectively eliminating some of the risk.
- Insuring a portfolio means finding a counterparty with whom you can enter into a contract whereby they agree to pay you for losses that occur in the portfolio or asset being insured. (see insurance)