Tuesday, October 23, 2012

Diversifcation: good but not as good as you probably think

Index cohesive force
Index cohesive force (Photo credit: Wikipedia)

For years (at least since 2001) this idea has been a mainstay in my classes.  The benefits of diversification have been overstated.  Why?  The correlations that are used to diversify and get the so called optimal portfolio change and the change is NOT in a random format: the correlations go up in bad times.

The Physics of Finance: Why diversification doesn't work:

"Harry Markowitz introduced the idea of diversification into investing back in the 1950s (at least he formalized the idea, which was probably around long before). Using information on the mathematical correlations between the returns of the different stocks in a portfolio, you can choose a weighted portfolio to minimize the overall portfolio of volatility for any expected return. This is maybe the most basic of all results in mathematical finance.

But it doesn't work; it suffers from the same problem as the balanced man in the canoe. This is clear from any number of studies over the past decade which show that the correlations between stocks change when markets move up or down."

Click through, this will almost assuredly be a test question for SIMM!

UPDATE 10/23/2012

It was rightly pointed out to me that this could be taken the wrong way.  I am not saying the benefits of diversification are non-existent and without any doubt all investors should be diversified across assets classes.  What I was trying to say is that the benefits are overstated as they are based on correlations that will likely climb in the event of a large scale market decline.  

Short term governments have HISTORICALLY been the exception to the rule and clearly derivatives that are designed to act like insurance contracts and have negative correlations (puts for the average investor) do not fall into the category of assets whose correlations increase in bad times.
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