By Sergey Savastiouk, Founder and CEO of Tickeron
Despite rampant volatility in recent weeks as global recession fears escalate, the U.S. financial markets historically display unparalleled power and resilience for long-term investors during times of uncertainty.
Although considerable investment returns are possible in the long run, volatility often wreaks havoc in the short run. The 2008 meltdown was painful for those close to retirement who were not properly diversified. Diversification amongst asset classes could have saved many American’s retirement plans during the Great Recession.
Strong diversification involves more than purchasing a variety of stocks. Individuals must also diversify among asset classes. This requires analysis of both asset selections and allocations. Achieving this used to be a complex business, many wealthy investors entrusted to hedge fund managers. The advent of artificial intelligence (AI) allows self-directed investors to diversify their holdings like a hedge fund pro.
Diversification helps eliminate the idiosyncratic risk
Every asset comes with idiosyncratic risks, which are the risks and uncertainties unique to that asset. To mitigate idiosyncratic risk from your portfolio, you must select assets with different types of idiosyncratic risks. This allows investors to make money even during idiosyncratic downdrafts. Although you can never completely eradicate systemic (industry) and systematic (broad market) risk, diversification can help you achieve alpha.
Why idiosyncratic risk is so dangerous
In 2001, many investors lost their life savings when Enron, once the darling of Wall Street, imploded like a collapsing star. In the years leading up to the crash, Enron management had even encouraged employees to contribute every cent of their retirement savings to Enron stock. This was an idiosyncratic risk on steroids.
This unfortunate example shows why idiosyncratic risks are so important to guard against. They are often very unique to a particular asset and difficult to foresee.
Diversification is the best defense
Effective diversification starts with analyzing the idiosyncratic risks of their asset classes. As many investors are in the process of saving for retirement, the threat of sequence risk increases. Sequence risk is the possibility that the market will suddenly cut portfolio values at the worst time. Unfortunately, this happened to many pre-retirees during the 2008 financial crisis.
Planning ahead and diversification go hand-in-hand. Investors who wish to avoid sequence risk should spend time analyzing their retirement asset classes. Two common retirement asset classes are 401(k) plans and individual portfolios. These vehicles offer a unique set of benefits and risks depending on the individual investor’s portfolio. No matter what retirement savings vehicle you have, diversification is universal. But how do you know when you are diversified enough to come out on top?
How AI is banishing idiosyncratic risk
Before AI, average retail investors had only blunt instruments for determining their diversification strategies. They were at a disadvantage compared to Wall Street firms that employed the quants and analysts necessary to coordinate correlations and asset weights.
Today’s state-of-the-art AI applications use knowledge and calculations to create algorithms capable of analyzing vast data sets and calculating ideal diversification strategies. These algorithms create diversification recommendations for individuals and portfolios within a click of a button.
Fintech is developing quickly
Technology continues to advance and provide platforms for those seeking innovative methods to access financial data in real-time. As a matter of fact, 56% of technology leaders believe artificial intelligence will change the way financial services are delivered within the next two years.
More innovative solutions are in the pipeline. A fintech explosion of algorithm-based tools is bringing sophisticated analysis once available only to the Wall Street elite to the Main Street investor. As AI continues to grow, self-directed investors and financial advisors will benefit from these tools that will help them navigate the financial industry.