The opportunity cost of diversification or the “Limitation of Or” that we’ve discussed previously, has been avoided by utilizing the “Power of And”: as the portfolio retains its stock and bond exposures AND gains meaningful exposures to diversifying and hedging strategies.
The Backdrop: Hedging Equity-Related Risk
Stocks generally make up a significant part of most investor portfolios, be they institutional or individual. Investors have been taught, and have come to believe, that stocks are a good investment for the long run, and their realized historical returns appear to support this story. What is sometimes overlooked, particularly during prolonged bull market runs, is that returns are high because they must compensate investors for the high degree of risk equity investing entails.
Most investors seek to mitigate stock risk by investing a part of their portfolio in bonds. The historically low correlation between stocks and bonds leads to diversification benefits: the risk and the return of a stock/bond portfolio are lower than those of just stocks. However, the reduction in risk is generally greater than the reduction in return, resulting in a higher risk-adjusted return.