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In the Market - May 2009
May 15, 2009
Diversification
Since late 2007, even managers of diversified portfolios did not enjoy the typical effects of diversification. Diversification works best when correlations between portfolio components remain negative or negligible. In bear markets, equity positions exhibit higher correlations than their norm. When dealing with a large portfolio, all of the positions interact with each other making it difficult to assess how diversified your portfolio is. Using portfolio optimization tools you can calculate your diversification benefit, but in bad market conditions that benefit is lost and fails to help the investor.
To illustrate this phenomenon, we have calculated the correlation between the 435 distinct correlation pairs of positions within the Dow Jones portfolio to find the portfolio variance. Using this portfolio variance, we then back out a constant correlation for the 435 pairs, which we will call the portfolio correlation. We calculated this portfolio correlation for the Dow Jones Industrial Average monthly since 2000 using a look back period of 3 months. See calculation below.
Looking at the chart below you will see that the portfolio correlation started to jump up in mid 2007. This corresponds with the peak of the Dow Jones. The peak of the correlation occurs in late 2008, this would correspond to the largest drop in the bear market we just went through. The other time we saw a large spike in the average correlation was the period of late 2000 to early 2003. This coincided with the tech bear market and the post 9/11 market. The spike in 2002 led to the average correlation heading north of .5. That period represented a major sell off in the Dow Jones. Looking at the chart we can see that an average correlation of over .5 should raise warning flags.
Diversification is a great method for mitigating risk, but it often proves illusory, especially when constructed within a single asset class. Fundamental diversification across asset classes and macro economics themes, while also imperfect, will often get closer to the moving target of diversification.