Monday, May 9, 2011

Where's diversification when you need it?

One of the rationales for the formulation of the Inflation-Deflation Timer Model was the failure of asset diversification in the Financial Crisis of 2008. During that panic episode, investors found that asset class return correlations converged to 1. All assets moved together because it was one giant risk trade. Even balanced funds failed to diversify risk.

In response, the Timer Model was built in such a way that during deflationary, or panic episodes, I analytically identified assets, i.e. risk-free US Treasuries, as the safety trade - without reference to any historical correlations.

I see that a number of others agree with my analytical approach to risk analysis. John Authers wrote the following in his book, The Fearful Rise of Markets:

In the future, it would make more sense to divide the world by risk. If an investment is not prone to the same risks as the others you already hold, then buying it will reduce your overall risk. If it is subject to exactly the same risk, then buying it is pointless, even if it is in a different asset class or country. Rather than balance between stocks and bonds, for example, it might be better to balance the risks of inflation and deflation, which both affect stocks and bonds. Diversification itself is as good an idea as ever. You should not put all your eggs in one basket. But in the globalized world, you can put your egg into a different country an still find that it is in the same basket.
EDHEC said the same thing, but in a slightly different way. (Note that my Timer Model is a dynamic asset allocation model) [emphasis added]:
The postmodern quantitative techniques suggested as extensions of mean-variance analysis, however, exploit diversification as a general method. Although diversification is most effective in extracting risk premia over reasonably long investment horizons and is a key component of sound risk management, it is ill-suited for loss control in severe market downturns. Hedging and insurance are better suited for loss control over short horizons. In particular, dynamic asset allocation techniques deal efficiently with general loss constraints because they preserve access to the upside. Diversification is still very useful in these strategies, as the performance of well-diversified building blocks helps finance the cost of insurance strategies.
When do you want risk control the most? During "normal" periods when diversification dampens volatility and returns? Or during extreme crisis events when standard diversification techniques break down?

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