Hedging

If one could reliably predict future returns, there would be no need or desire diversification; one would instead invest in the highest-returning asset at each point in time. Crystal balls, however, hardly exist in the real world, and investors do not know in advance how prices will evolve even in the near future. In order to enjoy a higher expected return, some risk must be taken. The goal of diversification is precisely to find the most efficient way to harvest risk premia across and within risky assets – in other words, earn the highest expected return for a given risk budget, and this is achieved by diversifying away the largest possible amount of unrewarded risk.