Portfolio diversification and hedging are the two basic private risk-management techniques

Evidence

The first and most basic risk-management technique in finance is called “portfolio diversification,” which tries to ensure that your portfolio of assets is not overly exposed to any single source of risk, except by conscious choice. One way to diversify is to try not to buy the same assets as everyone else. Instead, buy different assets, preferably ones that are uncorrelated or even negatively correlated to other folks’ assets. The second technique is hedging. Rather than simply rely on passive correlations that are out there in the world to ensure your safety, such as the inverse relationship that typically prevails between the USD and the euro, banks can adopt particular strategies, or trade derivative instruments with specific characteristics, so that the gains from one set of exposures covers (hedges) any losses in another. — Mark Blyth, Austerity, 101

Categorization

• DEFINE: Clean definitions of diversification and hedging, the two techniques Blyth will show failed catastrophically in 2008.
• XREF: connects to: Good diversification requires assets uncorrelated with each other and earning above cash returns — Mark Blyth, Austerity: The History of a Dangerous…, 715; Portfolio insurance is structurally equivalent to buying a put option on the portfolio. — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 791

Broader Connections

• Good diversification requires assets uncorrelated with each other and earning above cash returns #expands (0.78) — Mark Blyth, Austerity, 715