The following two letters are in response to our article, Why Diversification is Failing, which appeared last week. Sebastien Page of State Street Associates responds to these letters on page two of this article.
Dear Editor,
As usual, people who do mean variance analysis and don’t think about the inputs come out with the wrong answer. It has nothing to do with upside versus downside correlation asymmetry. It has to do with asset class valuations going into a correction. Like Jeremy Grantham said 18 months ago: bubbles, bubbles everywhere. Every asset class was overvalued. No wonder they all came down at the same time. If you are looking to diversify, don’t look at trailing correlations. Look for valuation disparities. Unfortunately, that would not have helped last year, when only cash worked. Too many people feel comfortable when they run models and do the math. People should think first.
Thanks for listening.
Phil Appel
Merrill Lynch
Bloomfield Hills, MI
Dear Editor,
Only the CFA Institute could come up with the following reason for why diversification is failing: “In short: diversification is failing because of correlation asymmetry.” They might consider a much simpler answer: Diversification is failing because correlations are greatly impacted by the underlying valuation of the securities involved. In bear markets, investors will sell overvalued assets in favor of less overvalued assets. The historical correlation of the assets will have little to do with it. After a five year run where the valuation of U.S. stocks, international stocks, commodities, and real estate, all went vertical due to the coordinated and determined efforts of global policy makers to reflate assets after the 2000-2002 bear market, it should have been obvious that the historical correlations of these asset classes could and should have been thrown out the window. Unless advisors learn that there are two methods of managing risk, diversification AND valuation, they will continually be bedeviled by “correlation asymmetry.”
Kenneth R. Solow
CFP, Chief Investment Officer
Pinnacle Advisory Group, Inc.
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