8Financial Innovation: Creating Value… or Risk?

8.1. Basic concepts of portfolio management

In this chapter, we will try to answer, based on the fundamental concepts of portfolio management, the following question: does financial innovation create value or risk for the investor? In order to do so, we will first go back to the fundamental concepts of portfolio management.

8.1.1. Diversification

The principle of diversification is widely known, both by financial asset management professionals and private individuals. However, while it seems simple, it is often misunderstood.

The general idea is that by combining different assets, we will reduce the risk of our portfolio. That’s right, but we need to be more specific!

In fact, it is important to return to the basic objective: what is the purpose of diversification? Yes, the objective is to reduce the risk of our portfolio, but in a very specific context: when the markets fall and in an extreme case, in the event of a crash.

Indeed, it is when the markets fall that investors want this decline to be cushioned. But cushioned by what? If you have a large number of financial assets in the portfolio, but they all fall at the same time, this is not very useful. This last remark may seem rather obvious, but it is very important to remember, as markets sometimes behave in a way that is described as gregarious. Thus, when equity markets fall, many financial assets suffer the same fate: real estate, commodities, high-yield bonds. This is ...

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