In this piece, Ted Lucas of Lattice Strategies discusses the relationship between correlation and diversification, as well as the intricate task of building investment portfolios that remain resilient during market drawdowns, yet retain upside participation during bull markets. To explore some of his other writings, they are all archived on Lattice Strategies’ website.
Risk, Capital Preservation, Compounding
“But ‘risk management’ on its own is an abstraction, as is ‘beating the market’ over a short time period, if the end goal is to generate a real capital growth over a longer time window…For an asset manager seeking to generate long-term real growth of capital, the design problem is creating a portfolio structure that can both withstand periods of market turbulence and capture returns when they are available.”
Lucas highlights a very real dilemma for all investors: the tricky task of reconciling the goals of capital growth (compounding) with capital preservation. The frequently mentioned “abstraction” of “risk management” is merely a tool available to each investor to be incorporated, if and when necessary, to assist with this task.
Correlation, Diversification
Prior to the financial crisis in 2008, people believed that correlations between asset classes had “decoupled” given new breakthroughs on how risk was redistributed in the financial and economic markets, etc. Investors paid dearly for this assumption when many asset classes (equity, high yield, real estate, commodities, etc.) originally believed to be uncorrelated, all plummeted in value at the same time.
With investors still licking 2008 wounds, the opposite is now occurring. As Lucas writes, “There is much recent discussion about asset correlations rising to such elevated levels that diversification has been rendered useless.”
Correlation of assets/securities has a meaningful impact on the effects of diversification. Afterall, as Jim Leitner astutely points out, “diversification only works when you have assets which are valued differently…” Therefore, if all the assets/securities in your portfolio are highly correlated, diversification would be rendered useless regardless of how many positions you hold.
Lucas believes that investor fear of high asset correlations are overdone. I don’t have enough evidence to either agree or disagree with this view. However, the investing masses have a tendency to project the near-term past into the long-term future, and today’s assumptions about elevated levels of asset correlation could very well be overdone.
Regardless of whether you believe today’s asset correlations are high or low, the takeaway is that your view on future asset/security correlations will (or at least it should) influence your portfolio allocation decisions, because it directly impacts diversification and the volatility profile of your return stream.
Definition of Investing
“Here is a basic idea: the purpose of investing is to grow whatever capital is invested in real terms.”