When an investment house or hedge fund has many positions, the risk of the house depends on how risks of those positions are related. If it is likely that all perform poorly at the same time, a higher probability of a huge portfolio loss exists.
Obviously, managers diversify risk by the type of investments they make. The idea is to be sure that securities which may fall in a certain market will be counter-balanced by others that will profit in that environment. The trick is mitigating hazard by manipulating correlation.
These risky correlations or probabilities of investment positions acting alike are often difficult to estimate and are subject to change over time. They may change abruptly. If small, there isn’t too much to fear. If unexpectedly large, random and sudden, there can be catastrophe.
In such instances, risk managers can never be expected to know what these correlations ought to exactly be. That is where investment fiascoes occur.
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