March 3, 2009
Diversification has long been considered an essential tool for those seeking to minimize their risk in a volatile market. But a recent study presented to the CFA Institute shows diversification doesn’t accomplish its goals, working best in up markets when investors could use a little less of it and failing to protect them in down markets when it’s needed most.
“Fear is more contagious than optimism,” says Sebastien Page, of State Street Associates, who wrote “The Myth of Diversification” along with his colleague David Chua and Mark Kritzman of Windham Capital Management.
Page presented the results of their study in a CFA Institute webcast, which was taped on December 8, 2008. It showed that, when both the US and the world (excluding the US) markets were up by more than one standard deviation above their mean, the correlation between them is 35%. When both are down by more than one standard deviation below their mean, their correlation rises to 85%, precisely the opposite of what investors desire.
In short: diversification is failing because of correlation asymmetry.
“It’s like having your head in the oven and your feet in a tub of ice; your overall body temperature might be okay but the chances of survival are pretty slim,” Page says.
It’s not just the US and non-US markets that let investors down. Diversification by style (growth versus value), size (small versus large cap), and across major sectors of the fixed income markets all exhibit the same undesirable property – greater correlation in down markets than in up markets.
Page and his co-authors provide the following data to illustrate correlations across a number of pairs of asset classes:
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