No Pain, No Premium

Summary

In this commentary, we discuss what we mean by the phrase, “no pain, no premium.”
We re-frame the discussion of portfolio construction from one about returns to one about risk and argue that without risk, there should be no expectation of return.
With a risk-based framework, we argue that investors inherently act as insurance companies, earning a premium for bearing risk. This risk often manifests as significant negative skew and kurtosis in the distribution of asset returns.
We introduce the philosophical limits of diversification, arguing that we should not be able to eliminate risk from the portfolio without eliminating return as well.
Therefore, we should seek to eliminate uncompensated risks while diversifying across compensated ones.
We explore the three axes of diversification – what, how, and when – and demonstrate how thinking in a correlation-driven, payoff-driven, and opportunity-driven framework may help investors find better diversification.