SmartETF

Diversification Can Be Everything

Good stuff Jim. I don’t believe folks have issue with asset allocation; but rather its reliance on mean variance; note that your chart uses a rolling 36 month moving average. Had you used traditional linear correlation and regression you would have not identified the dramatic swings in correlation over time. In fact, if you had used shorter intervals your swings would have been much larger; especially in times of extreme events (as correlations move towards +1); as the saying goes: the only thing that goes up in a down market is correlation.

Linear Correlation falls under the family of Dependency models. A more sophisticated dependency model that better represents a dynamic marketplace is a method called Copula Dependency; think of it as a dynamic correlation model that continually test the relationship between two securities.

The advantage of using a copula dependency model is that it would identify the increasing volatility in the marketplace (in conjunction with a GARCH model) and recognize that correlations would be advancing during large market moves and invest accordingly. In other words, it would recognize that assets that are traditionally non-correlated may become highly correlated during extreme events and therefore opt to invest in short-term treasuries as an alternative.

The mean-variance disciples use the laws of large numbers to forecast performance. Over the past 80 years the domestic equity market has returned 10% annually. Note that the market is down over the past 10 years (and 3 years, and 1 year, and YTD); just as it was from 1800 – 1815 (15), 1835 –1843 (8), 1852 – 1861 (9), 1880-1896 (16), 1907 – 1921 (14), 1930 – 1949 (19), 1968 – 1981 (13), 2000 – today (8). The down markets caused by deflation over the past 200 years lasted, in sequential order: 8, 16, 19, and so far 8 years. So mean-variance is like a clock that is right twice a day, even if broken. If an investor enters the market at the top of one of these long-term cycles it could easily take up to 30 to 40 years to break-even. Let mean-variance R.I.P. and take a look at Extreme Value Theory.