Ecoinometrics - How to think about the correlations risk
When building a portfolio it is rare to make purely independent bets. Said differently, you can't neglect thinking about correlations.
You are building a portfolio of bets. Each bet has a given probability of playing out in your favour. Now the thing is most likely those bets aren’t independent. This can be good or bad. But when building your portfolio, you can’t neglect thinking about correlations.
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How to think about the correlations risk
One thing we like to have in our portfolio is asymmetric bets. Great upside potential. Low risk. They are our favourite tool.
Even if you have a bunch of asymmetric bets there is always risk that none of them will pay off. That’s the nature of dealing with probabilities.
Say you have four bets in your portfolio each with a 50% chance to win. Assuming they are independent bets, the probability that all of them turn out to be losers is 6.25%. That’s not a huge but that’s large enough that over a period of time this will happen.
The key assumption here is that those bets are independent. Because if they are actually correlated, your odds could be worse than that. And it turns out in finance, there aren’t too many assets that stay uncorrelated at all time.
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