Is diversification working today, when we need it most? EFF/KRF: When overall market volatility increases, idiosyncratic (security-specific) volatility also tends to increase. For example, market volatility is currently quite high, and the dispersion of the cross section of stock returns (which is idiosyncratic volatility) is also unusually high. Diversification has no effect on the volatility of the overall market, but it reduces the effect of idiosyncratic volatility on a portfolio's return. To put it differently, active investment is a riskier strategy when volatility is high because active portfolios are, almost by definition, poorly diversified. In short, diversification is now more important than usual.
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