Is your portfolio truly diversified? Unveiling the significance of 'factor' diversification
This outcome is unfortunate yet entirely preventable. The key? Put your eggs in different baskets. That way, should one basket tumble, the other eggs remain safe.
But what if all your baskets rest on the same tray?
If the tray topples, all your eggs will be crushed, even if you adhere to the wisdom of spreading them across baskets.
In investing parlance, the baskets represent securities, and the trays symbolize sectors. Therefore, it's not only advised to spread your investments across different stocks but also different sectors.
This principle is widely accepted, but sectors are not the only form of trays that need diversification. A lesser-known tray is 'factors'. You might have diversified away from sectors, but you are in trouble if all your stocks are still exposed to the same factor, and it’s a dull time for that factor.
Another nuance to this is that diversification should occur in negatively correlated spaces. It wouldn’t matter if you have diversified over hundreds of baskets or trays; if they are highly correlated, the whole purpose of diversification gets defeated.
But let us put this to the test. What does diversification of factors look like, and which different factors have negative correlations?
Negative Correlation: The Intricacies of Factors at Play
Ever seen a see-saw? One side goes down, the other goes up — simple physics. Finance, though, isn't that straightforward. But, there are some observable patterns, especially when it comes to factors like Value and Momentum.
Let us break it
