Common Misconceptions: Diversification and the Correlation Caveat
First, three intertwined lessons with added commentary from some of the best:
1)Get familair with the appropriate amount of discomfort, it's often the portfolio’s future best friend.
You are not truly diversified until you own something you are really uncomfortable with.
—Peter Bernstein
You often meet your fate on the road you take to avoid it.
—French proverb
Maybe all one can do is hope to end up with the right regrets.
—Arthur Miller
2)Stay critical of calculations, especially new and “innovative” ones eager to stake their claim.
Are there dangers in getting too caught up in the minutiae of using a computer so that you miss the organized common sense? There are huge dangers. There’ll always be huge dangers. People calculate too much and think too little.
—Charlie Munger
3)Reflect on diversification-decisions as honestly as possible; and keep a record of future big diversification-decisions going forward.
All our final decisions are made in a state of mind that is not going to last.
—Marcel Proust
Those who do not remember the past are condemned to repeat it.
—George Santana
The one who thinks over his experiences most, and weaves them into system relations with each other, will be the one with the best memory.
—William James
My inner twelve-year-old is still upset with the magazine that advertised “bargain” sunglasses for $11.99. High-quality sunglasses direct! They said. I got what I asked for just not what I wanted.
Diversification has been called the only free lunch in investing, but free meals can be expensive when investors don't understand the fine print. Take this excerpt from a Morningstar article written in 2010:
Prior to the 2007 crash, many of us thought that as long as our portfolios were diversified among several standard equity and fixed-income asset classes, a dip in one would be balanced out by another, and it wouldn't be too long before we'd be back on track in working toward our investment goals. Still, most of us lost big chunks of our nest eggs in the recent financial crisis. As the S&P 500 Index and core-type large-blend funds, on average, lost 55% between October 2007 and March 2009, every other major asset class, with the exception of government bonds, also swam in red ink. Thus, even "diversified" portfolios experienced major losses.
Truth is, throughout history investors have not handled the concept of diversification with as much care as it deserves. That's a big problem because diversification plays a lead role in a portfolio. For perspective, let’s look at an explanation from David Swensen, the longtime manager and architect of the most successful endowment fund the world has known.
Swensen, from his 2005 book Unconventional Success:
Investors tend to seek diversification when the core portfolio asset disappoints, either in absolute or in relative terms. For instance, in January 1993, after an extended period of poor relative foreign equity market performance, international market exposure accounted for only 5
percent of the aggregate of mutual-fund equity holdings. In 1993 and 1994 foreign developed stock markets reversed the trend, outpacing the U.S. market by an aggregate of 29 percent. Mutual-fund investors, attracted by strong relative performance in October 1994, boosted foreign holdings to an all-time high of 14 percent of equities, more than tripling the allocation in less than two years. As might be expected from performance-chasing activity, the timing of the diversification move proved costly. For four successive years, domestic markets again outperformed foreign markets, with foreign investors dropping an aggregate of 84 percentage points of performance relative to domestic investors. As of January 1999, holders of mutual funds, far less enamored of the now-lagging overseas markets, reduced foreign equity positions by more than 40 percent, leaving foreign mutual-fund exposure at 8 percent of equity investments.
Strong relative performance of foreign equities caused mutual-fund owners to dramatically increase non-U.S. equity holdings, with investors frequently citing diversification as the rationale for boosting foreign allocations. Disappointing performance from the diversifying asset caused investors to reduce allocations at an inopportune time. Sensible investors pursue diversification as a policy to reduce risk, not as a tactic to chase performance.
The takeaway here is investors should stay critical of the reasons they might “diversify" at any particular moment. This is especially true in the age of information. In modern times powerful personal computers now make portfolio analytic tools widely available to anyone interested in using. In theory these tools add additional insights; in practice they've left investors much less prepared than they thought they were. One of the biggest, if not thee biggest, issues relates to the misuse of correlation.
For those that aren’t familiar, correlation measures how strongly two asset classes relate with one another, from a scale of -1 to +1. A negative correlation happens when one asset increases while the other decreases. A positive correlation happens when both values increase together. If markets are falling, investors tend to want or need something that offsets the stress. This offset would generally comes from negatively-correlated assets or assets with a low-level of positive correlation with what's under stress.
Correlation as a decision-tool is often so dangerous becuase people fail to account for how correlation changes through time. That's a problem given the important role correlation plays in building an investment portfolio. Charlie Munger may have summed the this risk up best: “If you mix raisins with turds, you've still got turds.”
To elaborate, here is Howard Marks — the founder of Oaktree Capital and author of a market memo that Buffett has claimed is one of his favorite and reads — from his book The Most Important Thing:
Everyone knows assets have prospective returns and risks, and they’re possible to guess at. But few people understand asset correlation: how one asset will react to a change in another, or that two assets will react similarly to a change in a third. Understanding and anticipating the power of correlation—and thus the limitations of diversification—is a principal aspect of risk control and portfolio management, but it’s very hard to accomplish. The failure to correctly anticipate co-movement within a portfolio is a critical source of investment error.
Investors often fail to appreciate the common threads that run through portfolios. Everyone knows that if one automaker’s stock falls, factors they have in common could make all auto stocks decline simultaneously. Fewer people understand the connections that could make all U.S. stocks fall, or all stocks in the developed world, or all stocks worldwide, or all stocks and bonds, etc.
So failure of imagination consists in the first instance of not anticipating the possible extremeness of future events, and in the second instance of failing to understand the knock-on consequences of extreme events.
What investors need to know is diversification does not come from owning a bunch of assets, it comes from owning assets that will act differently from one another, when it matters.
The investors in the aforementioned Morningstar article failed to realize that correlation relationships are not stable. They have a long history of changing — sometimes gradually, other times with incredible speed. But after so many years of poor performance from US stock, investors, brokers and financial advisors were in the mood to “diversify” into basically everything else. Using now widely available computer-driven analytics tools they embraced a diversification system — tested against known conditions of the recent past — that appeared to offer the resilience investors craved.
Unfortunately, the correlation numbers the computers pooped out were crap. Not because they were wrong, but because the historical correlations were used as inputs to gauge the future risk in uncritical and comfort-seeking ways. This lead to a crappy future-portfolio: low-return, high-risk. The exact opposite outcome investors were hoping for.
It wasn’t just Main Street that would be caught off guard. Much of Wall Street was happy to trust the correlation numbers as long as they put big profits in their pockets, which eventually turned into massive losses for shareholders. The book turned movie The Big Short provides an incredible overview of how that problem played out.
Three lessons:
1)Get familiar with the appropriate amount of discomfort, it often the portfolio’s future best friend.
2)Stay critical of calculations especially new and “innovative” ones eager to stake their claim.
3)Reflect on diversification-decisions as honestly as possible; and keep a record of future big diversification-decisions going forward.