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The Math of Diversification

Top 5 of the Week of December 24th

SR-SV’s editor Ralph Sueppel heads up our penultimate Top 5 of the Week for 2018 with an examination of risk-free interest rates. Nicolas Rabener from Factor Research looks at micro and small caps factor investing. And Wesley Gray, PhD, writing for Alpha Architect discusses the pros and cons of diversification.

Michael Harris, from Price Action Lab, reveals what is worse than giving random trading tips. A Teachable Moment’s Anthony Isola reflects on the only benchmark that’s important…


Why There Is More Than One Risk-Free Interest Rate

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  • Having separate market segments (where structured trades replicate rates) means that the financial market delivers more than just one risk-free interest rate
  • This happens because financial frictions can block arbitrage and some risk-free assets deliver extra convenient yields, due to their liquidity and suitability as collateral
  • Which means that there are safe assets that are adaptable, “impervious to convenience yields,” and enduring after temporary mark-to-market losses

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Small Is Mighty

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  • Huge market-cap stocks are scrutinized by large numbers of well-trained financial analysts, yet there could be worth in examining companies with less coverage
  • A scarcity of analysts screening such assets could be an untapped alpha-generating chance, but undergoing such analysis by hand is not a great idea
  • However, it’s possible to apply systematic frameworks in factor investing through indices with the highest returns potential from small caps when weighted by market cap

How small are your investments? Share your comments in the section below

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The Math of Diversification

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  • As the math proves, grouping a large number of uncorrelated bets together reduces risk as there is less volatility but the same 10% expected returns
  • However, the math of diversification can get you into trouble if you rely on it without considering the possiblity of a financial meltdown—which causes all bets to be off
  • Because the world doesn’t act like an ideal bell curve, it can’t be measured through expected returns and covariance matrices—think outside the box to make diversification work

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The Power of Wrong Investment Advice

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  • Providing the wrong investment advice to public investors on financial/social media can have more devastating effects than random trading tips for market speculators
  • Because those who follow random tips which incur a loss tend to be a much smaller group than those investors nearer retirement age who may not have the time to recoup any losses that occur from following the wrong advice
  • If you’re on social media, it’s more important to focus on the type of advice being delivered on these forums than shady market tips

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The Correct Unit of Measurement for Wealth

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  • Investment advisors need to make a shift and help their clients understand the most fundamental criteria for measuring wealth—happiness
  • Teaching those how to value their wealth against their happiness is a truly responsible investment advisory service as assets are meaningless if they’re not attached to meaning in life
  • Changing your philosophy to the evidence-based plan for happiness is the ideal to balance your contentment with your investments through connection, control, competence, and context

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Top 5 of the Week is a summarized collection of financial investment articles that we like and think you might like too. Having written thousands of pages of equity strategy and company research between us, we understand the allure of the ever-changing world of finance. Investing is an art form—and like everything, something you can work on and improve at. There are some excellent writers out there on the finance web, some offer a running commentary on today’s market, some are doing research, some have tips on how to Become a Better Investor, and some just lift the cloud of fog behind a lot of financial jargon. Each week we will keep you up to date with the top 5 articles worthy of your attention.


 

Anything you would like to discuss about this week’s top 5? Do you have another favorite that isn’t mentioned here? Feel free to add it below. Let’s start a discussion in the comments section!

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DISCLAIMER: This content is for information purposes only. It is not intended to be investment advice. Readers should not consider statements made by the author(s) as formal recommendations and should consult their financial advisor before making any investment decisions. While the information provided is believed to be accurate, it may include errors or inaccuracies. The author(s) cannot be held liable for any actions taken as a result of reading this article. The Become a Better Investor Team doesn’t necessarily endorse any stocks or shares mentioned in the articles or the author of such articles linked to and summarized in Top 5 of the Week and cannot guarantee the accuracy of its information.