Diversification and Risk Management: What Volatility Tells Us

Abstract

Investors may not be as well diversified as they would like to be, or think they are, particularly in times of market turbulence. This article shows that most investments perform poorly in periods of rising risk aversion, proxied by changes in the VIX, a popular gauge of risk. Such investments are said to be “short volatility.” That is, they provide positive returns under typical market conditions, but give them back in times of stress. Only a small minority of investments perform well when risk aversion rises, and these are known as “long volatility.” A third category of investments is uncorrelated to the risk environment. Investors concerned about portfolio returns in turbulent markets should focus less on traditional asset class designations and hold portfolios diversified across short and long volatility investments and investments uncorrelated to volatility.

TOPICS: Risk management, volatility measures, performance measurement