By the end of this lesson you understand what concentration risk is and why having too much capital in too few positions increases it.
\nModule 2 explained that diversifying -- combining assets that don't all behave the same way -- reduces a portfolio's risk without proportionally reducing its expected return. This module develops the mechanisms behind that idea in more depth. This first lesson names the problem diversification solves: concentration risk.
\nConcentration risk is the risk that arises from having too much capital invested in too few positions, sectors, or geographic regions, such that a single event can affect a disproportionate part of the portfolio. It isn't a different kind of uncertainty from risk, already covered in Level 1 -- it's a specific form of risk that depends on how the portfolio as a whole is structured, not on the uncertainty of each asset considered separately. A portfolio can have high concentration risk even if, individually, none of its positions seems especially risky: the problem isn't in each asset, but in how much combined weight a few of them carry relative to the total.
\nConcentration can occur along more than one dimension at once -- too few positions overall, too much weight in a single sector, too much weight in a single geographic region, both already covered in Module 2 -- and all share the same underlying problem: when something specifically affects that concentration, a disproportionate part of the portfolio gets hit at once. Diversifying, already covered in Module 2, is precisely the practice that reduces this risk, spreading capital so that no specific event weighs so heavily on the whole.
\nA portfolio with 90% of its capital in a single company has very high concentration risk: a problem specific to that company -- a bad management decision, the loss of a major client -- directly affects the vast majority of the portfolio. A portfolio with that same capital spread across several companies in different sectors and regions has much lower concentration risk, even though the risk of each individual company, considered separately, is similar in both cases.
\nConcentration risk is the risk that arises from having too much capital in too few positions, sectors, or geographic regions -- a specific form of risk derived from the portfolio's structure, not the uncertainty of each asset separately. Diversifying is the practice that reduces it.
\nWhy can a portfolio have high concentration risk even though none of its positions, considered separately, seems especially risky?
\nIn what different dimensions can concentration occur within a portfolio?
","sortOrder":1,"readingMinutes":7,"difficulty":"Intermedio"},"previous":null,"next":{"id":75,"moduleId":27,"slug":"what-is-correlation-between-assets","title":"What is correlation between assets?","summary":"You understand what correlation between assets is and why it's the real mechanism through which diversifying reduces risk.","bodyMarkdown":"## Objectives\n\nBy the end of this lesson you understand what correlation between assets is and why it's the real mechanism through which diversifying reduces risk.\n\n## Content\n\nThe previous lesson introduced concentration risk -- the problem diversifying solves. This lesson names the mechanism that makes diversifying work: correlation between assets, something Module 2 described only in qualitative terms, without naming it.\n\nCorrelation measures the tendency of two assets to move in the same direction, in opposite directions, or independently, in response to the same events. Two highly correlated assets tend to rise and fall together: what affects one tends to affect the other similarly. Two assets with low, or even negative, correlation don't move similarly -- they can react differently, or even in opposite directions, to the same event.\n\nThis is precisely what makes diversifying work: combining assets with low correlation to each other reduces the portfolio's overall risk more than combining highly correlated assets would, even if both combinations spread the same capital across the same number of positions. Two companies in the same sector tend to have higher correlation with each other than two companies in unrelated sectors, because they share more factors that affect them similarly -- the same idea as sector diversification, already covered in Module 2, now explained from its underlying mechanism.\n\nIt's important not to confuse correlation with volatility, already covered in Level 1: volatility measures how much a single asset moves on its own, while correlation measures how two assets move relative to each other. They're distinct properties -- an asset can be very volatile and, at the same time, have low correlation with another asset in the portfolio, and a low-volatility asset can still be highly correlated with another.\n\n## Example\n\nTwo companies in the same tech sector tend to rise and fall together in response to news affecting that sector -- they have high correlation. A tech company and a company in an unrelated sector -- food, for example -- don't usually react the same way to that same news: their correlation is lower, and combining them reduces the portfolio's overall risk more than combining two similar tech companies would.\n\n## Common mistakes\n\n- Thinking combining many assets is enough for good diversification, without considering whether they're correlated with each other.\n- Confusing correlation with volatility -- a low-volatility asset can still be highly correlated with another, and a highly volatile asset can have low correlation with the rest of the portfolio.\n\n## Summary\n\nCorrelation measures how two assets move relative to each other in response to the same events -- the real mechanism through which combining low-correlation assets reduces a portfolio's risk more than combining highly correlated ones. It shouldn't be confused with volatility, which measures how much a single asset moves on its own.\n\n## Self-check\n\nWhy does combining low-correlation assets reduce a portfolio's risk more than combining highly correlated assets?\n\nWhy are correlation and volatility distinct properties of an asset?","bodyHtml":"By the end of this lesson you understand what correlation between assets is and why it's the real mechanism through which diversifying reduces risk.
\nThe previous lesson introduced concentration risk -- the problem diversifying solves. This lesson names the mechanism that makes diversifying work: correlation between assets, something Module 2 described only in qualitative terms, without naming it.
\nCorrelation measures the tendency of two assets to move in the same direction, in opposite directions, or independently, in response to the same events. Two highly correlated assets tend to rise and fall together: what affects one tends to affect the other similarly. Two assets with low, or even negative, correlation don't move similarly -- they can react differently, or even in opposite directions, to the same event.
\nThis is precisely what makes diversifying work: combining assets with low correlation to each other reduces the portfolio's overall risk more than combining highly correlated assets would, even if both combinations spread the same capital across the same number of positions. Two companies in the same sector tend to have higher correlation with each other than two companies in unrelated sectors, because they share more factors that affect them similarly -- the same idea as sector diversification, already covered in Module 2, now explained from its underlying mechanism.
\nIt's important not to confuse correlation with volatility, already covered in Level 1: volatility measures how much a single asset moves on its own, while correlation measures how two assets move relative to each other. They're distinct properties -- an asset can be very volatile and, at the same time, have low correlation with another asset in the portfolio, and a low-volatility asset can still be highly correlated with another.
\nTwo companies in the same tech sector tend to rise and fall together in response to news affecting that sector -- they have high correlation. A tech company and a company in an unrelated sector -- food, for example -- don't usually react the same way to that same news: their correlation is lower, and combining them reduces the portfolio's overall risk more than combining two similar tech companies would.
\nCorrelation measures how two assets move relative to each other in response to the same events -- the real mechanism through which combining low-correlation assets reduces a portfolio's risk more than combining highly correlated ones. It shouldn't be confused with volatility, which measures how much a single asset moves on its own.
\nWhy does combining low-correlation assets reduce a portfolio's risk more than combining highly correlated assets?
\nWhy are correlation and volatility distinct properties of an asset?
","sortOrder":2,"readingMinutes":7,"difficulty":"Intermedio"},"pathContext":null,"curatedLinks":{"prerequisite":[],"continuation":[],"related":[]},"relatedConcepts":[{"concept":{"id":82,"slug":"concentration-risk","term":"Concentration risk","shortDefinition":"The risk that arises from having too much capital in too few positions, sectors, or geographic regions, such that a single event can affect a disproportionate part of the portfolio -- reduced by diversification.","longDefinition":"Concentration risk is the risk that arises from having too much capital invested in too few positions, sectors, or geographic regions, such that a single event can affect a disproportionate part of the portfolio. It isn't a different kind of uncertainty from risk, already covered in Level 1 -- it's a specific form of risk that depends on how the portfolio as a whole is structured, not on the uncertainty of each asset considered separately: a portfolio can have high concentration risk even if no individual position, considered on its own, is especially risky. Diversification, already covered in Module 2, is precisely the practice that reduces this risk."}}]}