In A Crisis, Correlation Goes To One
Diversification is a wonderful thing. It can increase the return and decrease the risk of your portfolio if used properly; however, it’s not a magic bullet. As we’ve been reminded in the last 18 months, even the best-diversified portfolio isn’t immune from precipitous declines.
Investors, unfortunately, are far too quick to abandon winning strategies after short periods of under-performance, and the financial media shares no small part of the blame. Consider the sensationalist pornography recently published by Vanity Fair, hardly a bastion of level-headed financial news, regarding the Harvard endowment’s recent poor showing.
No Strategy Works All The Time
Harvard’s endowment, by far the largest in the nation, returned an average of 14.1% per year from 1990 through 2008, only to lose 30% of its value last year. That 30% loss, according to Vanity Fair editor Nina Monk, was the result of excessive risk-taking and represent an unacceptable loss. But is it really? Even factoring in last year’s massive loss, the Harvard endowment has returned an average of 12.08% per year over the past 19 years. Looked at from a long-term perspective, last year was hardly a catastrophe and Harvard’s long-term returns remain quite impressive.
So what’s wrong with Harvard’s strategy (the same one followed by David Swensen, manager of the Yale endowment and author of the groundbreaking book Unconventional Success)? Nothing, it turns out, as Harvard’s long-term record clearly demonstrates. So why all the bad press? Simple, investors are obsessed with meaningless fluctuations in short-term performance and the financial media is more than happy to give the people what they want.
In A Crisis, Correlation Goes To One
I think Harvard’s plight illustrates an important concept most people ignore: in a true crisis, the correlation of many normally-uncorrelated asset classes suddenly goes to one. That is, asset classes whose returns normally bare very little resemblence to each other tend to all drop at once in a crisis.
This phenomenon has happened many times before, most notably during the drop of 1987 and The Great Depression, when many (though of course not all) otherwise unrelated asset classes dropped in tandem. Unfortunately, it seems diversification fails us just when we need it the most.
The solution? Stay the course, keeping in mind that no strategy, not even one as sound as the highly-diversified strategy the Harvard endowment was following will work all the time. In investing, there is always risk and sometimes the chips simply won’t fall your way. But that’s no reason to change a working strategy.
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I really enjoyed a Wealth Track interview a couple months back with David Swenson. One thing he mentioned is that in a true crisis, investors only care about one thing: Risk.
When people get scared, they pull money out of every asset with a hint of risk, and pour it into the lowest-risk thing they can find. And as a result, real estate prices go down, U.S. stock prices go down, international stock prices go down, and corporate bond prices go down, etc…while everybody flocks to U.S. Treasury securities.
It shouldn’t be a surprise that correlation moves towards one in such a scenario. To write off the benefits of diversification is to misunderstand what it was intended for in the first place.
I got calls from clients questioning whether diversification still work. Here is what I told them.
Normally, asset prices are driven by multiple economic factors: interest rate, inflation, exchange rate, etc. Fear and greed pay an important but not overwhelming role.
In crisis however, the only driver is fear. Investors only see two asset classes: riskless assets (Treasury and gold) vs the rest (risky assets). They don’t make distinction among risky assets.
The market will not be forever driven by fear. At some point, other economic factors will resume their price setting roles. When the time comes, risky assets will no longer move in locked step and the benefit of diversification will manifest itself.
I agree that staying the course during times when the market is in panic is key. However my impression of the endowment situation is that because they are required to produce cash on a regular basis to the University, being over invested especially in less liquid investments puts them in a bad situation when panic strikes. They either have to try and cut spending that is funded by the endowment or sell at a loss to provide the required cash. I think one key to sticking with the course is making sure that in good times or bad you have the cash reserves to do so. This goes for any investor.