The Myth of Diversification Reconsidered
28 Pages Posted: 11 Feb 2021
Date Written: February 3, 2021
That investors should diversify their portfolios is a core principle of modern finance. Yet there are some periods where diversification is undesirable. When the portfolio’s main growth engine performs well, investors prefer the opposite of diversification. An ideal complement to the growth engine would provide diversification when it performs poorly and unification when it performs well. Numerous studies have presented evidence of asymmetric correlations between assets. Unfortunately, this asymmetry is often of the undesirable variety: it is characterized by downside unification and upside diversification. In other words, diversification often disappears when it is most needed. In this article we highlight a fundamental flaw in the way that some prior studies have measured correlation asymmetry. Because they estimate downside correlations from subsamples where both assets perform poorly, they ignore instances of “successful” diversification; that is, periods where one asset’s gains offset the other’s losses. We propose instead that investors measure what matters: the degree to which a given asset diversifies the main growth engine when it underperforms. This approach yields starkly different conclusions, particularly for asset pairs with low full sample correlation. In this paper we review correlation mathematics, highlight the flaw in prior studies, motivate the correct approach, and present an empirical analysis of correlation asymmetry across major asset classes.
Keywords: Bivariate normal distribution, conditional correlation, correlation asymmetry, correlation profile, exceedance correlation, full scale optimization, mean variance optimization, tail dependence
JEL Classification: C00, C10, C15, G11
Suggested Citation: Suggested Citation