Over the years, investors have viewed diversification as the only “true free lunch.” In fact, asset classes such as world equity markets, real estate, lumber, commodities, managed futures, and other alternative assets have been of great use to their proponents. On the other hand, some analysts argue that the benefits of diversification crumble at the worst possible times. This appears to be true, as evidenced by the recent financial crisis, in which well-diversified portfolios shrank by -25% or more. How can both sides of the argument be true? Is there anything a donation or an institutional investor can do?
Using best practices from institutional investing and hedge fund strategies, and applying a mathematical and scientific approach to improve statistical and risk management concepts, can maximize the use of information and the potential for diversification. available. It is useful to apply theoretical approaches in a sensible way to ensure practical and robust results in our pragmatic world. The result is a more complete model that combines Monte Carlo, Post-MPT analysis, and more meaningful risk measures. Here are some thoughts on these statistical measures and methods.
Global stocks, increasing correlations, and semi-correlation
Beginning in the 1980s, international stocks were the most important investment category. They added diversification to a well diversified portfolio. The Japanese stock market moved from around 10,000 to around 40,000 during the 1980s and helped spur interest in foreign stocks. Equity markets in the US, Europe, and Asia have always been correlated with each other, but the correlations were typically in the range of 0.4 to 0.7 before the mid-1990s.
Mean variance and other models of modern portfolio theory were “happy” to see these relatively low correlations. Portfolio optimizers have shown that you can slightly increase your overall equity exposure, allocate a significant amount of your equity exposure to other regions of the world, and still increase the overall risk / return characteristics of your portfolio. Over the years, international stocks (rather than just home country stocks) have performed well in diversified portfolios.
However, as with most good ideas, the payoff from international stocks declined over the years. Mathematically, there will always be some benefit to global stocks, but the numbers show generally increasing (continuous) levels of correlation over the years. Correlations between foreign stocks and the S&P have risen from an average of around 0.5 or 0.6 in the late 1980s and early 1990s (when international stocks started to become popular) to current levels of around 0.8 or 0.9.
Key takeaways:
- Correlations between world stock markets have generally increased over the years; the benefits of diversification diminished.
- Interestingly, there are peaks in the correlation, especially in times of financial crisis. Note the peak of the 1987 crash, as well as the very high correlations during the current recession.
- The previous point quantifies the observation of many investment analysts: that the diversification benefits of many asset classes are less than expected.
Semi-correlation
In general, we have seen that markets sometimes fall together, and the benefits of diversification dissipate, at the worst of times. When there is turmoil, markets become more correlated as portfolio managers cut losses and try to maintain liquidity. I have developed proprietary indicators (* is an example, below) to determine if diversification could really help in times of need.
Correlations and semi-correlations for S&P 500 and various sectors (1987-present)
Nasdaq-S & P correlation = 0.84
Europe-S & P correlation = 0.80
Asia-S & P correlation = 0.69
Semi-Correl
Nasdaq-S & P = 0.95
Semi-Correl
Europe-S & P = 0.93
Semi-Correl
Asia-S & P = 0.82
I sometimes mention “half deviation” as a better measure of overall risk than standard deviation (because it measures downside risk). Semi-correlation is a similar approach that removes some of the noise (noise due to bullish movements / correlation) and attempts to measure “trouble times” more directly. In the graph above, we can see that the correlations increase during financial market volatility. More specifically, the chart shows that when the S&P fell, the Nasdaq, European and Asian markets were down about 90% of the time. In fact, if we study the “material” declines, the diversification figures worsen to close to 100%.
Real estate correlation over time (1982-present)
Real estate is another asset class that has provided good diversification over the years, with a long-term correlation with values around 0.1. Based on data from 1982 to the present, we have seen correlations increase from about 0.0 to recent correlations closer to 0.3 or more, with the recent financial crisis closely related to the real estate sector. Summary
The correlation of some asset classes has increased over the years. Furthermore, history has shown that the real benefits of diversification are lower than expected, as markets fall together during market crises. Using a good set of tools can help investors gain a more realistic understanding of the odds. These tools have uncovered some interesting relationships between asset classes and strategies. Furthermore, financial markets and the world around us are constantly evolving. The value of a good idea often diminishes over time. What will be the next great investment idea? It is important to constantly improve to remain competitive in our fast-moving world. Ongoing research and a collaborative effort, with a trained investment team, can help an organization stay ahead and achieve good risk-adjusted returns.