Wednesday, February 04, 2009

More evidence that correlations increase in bad times

In the typical "wow what great timing" yesterday as we were talking about correlations and diversification in class, SeekingAlpha ran the following article:

Opportunities in a High Correlation World -- Seeking Alpha:
"One of the most striking features of 2008 was the fact that correlations between most asset classes went up substantially: everything declined at the same time. One of the principal motivations behind diversifying is that all of your holdings will not decline at the same time. Declines in one class will be buffered by gains in another—or at least lesser losses in others. This effect has not provided much buffer in 2008."
The article provides some very interesting correlation matrices (uh, that sentence may never have been written before!) showing how correlations went way up as market prices went way down.

This is not the first time that has happened. In fact, it seems to be the norm. Butler and Joaquin (2001) showed the same thing. From their paper Are the Gains from International Portfolio Diversification Exaggerated? The Influence of Downside Risk in Bear Markets:
"The fundamental rationale for international portfolio diversification is that it expands the opportunities for gains from portfolio diversification beyond those that are available through domestic securities. However, if international stock market correlations are higher than normal in bear markets, then international diversification will fail to yie ld the promised gains just when they are needed most...."
This does not mean to not diversify, but rather to realize that diversification may not be enough and that in bad times, you have to expect all assets to more together more. This can help explain why puts (that move in opposite directions) and cash are in such demand during bear markets.

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