Monetary correlation and the death of Diversification
Good, anonymous, article entitled "all fall down" (subscriber only) in the FT.
The gist is simple enough: the investment theory of diversification was based on the fact that asset classes performances are uncorrelated and by spreading your bets, you will hedge your risk. Since the assets are uncorrelated, you never get stuck with all down. So when ALL asset classes go down in value, together, what does that tell you?
The article draws 2 conclusions 1/ one the monetary one, on a decreasing volume of money prices will go down as indexed on this money 'gauge'. Remember if inflation is always and everywhere a monetary phenomenon, so is deflation. When all prices go down together isn't it a sign of indiscriminate monetary impact? All boats go down in a low tide. 2/ investors are correlated, through psychology and leverage, in their selling behavior and if they are all diversified then all asset classes get hit which defeats the purposes of diversification in the first place.
Interesting... it means diversification in the short run is a mediocre strategy and in the long run is ultimately self-defeating. I think diversification just joined buy-and-hold on the heap of discredited and discarded investment strategies. RIP.
The gist is simple enough: the investment theory of diversification was based on the fact that asset classes performances are uncorrelated and by spreading your bets, you will hedge your risk. Since the assets are uncorrelated, you never get stuck with all down. So when ALL asset classes go down in value, together, what does that tell you?
The article draws 2 conclusions 1/ one the monetary one, on a decreasing volume of money prices will go down as indexed on this money 'gauge'. Remember if inflation is always and everywhere a monetary phenomenon, so is deflation. When all prices go down together isn't it a sign of indiscriminate monetary impact? All boats go down in a low tide. 2/ investors are correlated, through psychology and leverage, in their selling behavior and if they are all diversified then all asset classes get hit which defeats the purposes of diversification in the first place.
Interesting... it means diversification in the short run is a mediocre strategy and in the long run is ultimately self-defeating. I think diversification just joined buy-and-hold on the heap of discredited and discarded investment strategies. RIP.
Comments
The reality is that some things are down much more than others (AIG vs. BUD, for example), and diversification can help ensure that you don't have all your eggs in one basket and lose everything unnecessarily.
I had my father in-law lecturing to me this Christmas on how I needed to diversify with him boasting, "I only lost 19% where the general market lost 50%". I preceded to tell him I lost 0% and actually pull in 5% tax-equivalent because I hold bonds and avoid fund like the plague. I'm probably a bad investor and too cautious, but IDC.
Stocks are historically the best performing assets. The buy and hold strategy is the best because it minimizes transaction costs and it is extremely hard to time the market.
I warmly recommend Barton Bigg's book, War Wealth and Wisdom on that topic.
Back to inflation and deflation:
Originally, inflation and deflation were - by their very definition - monetary phenomenons. The words respectively referred to inflation and deflation of the monetary mass. In an expending economy, you could have a steady drop of the price level without a "deflation".
The shift in definition to "change of the price level" was politically motivated. If inflation is a change in the price level, then surely the evil people who set the price can be blamed, or at least unknown market forces, not the government's press.
The policy aiming at stabilizing the price level is really an inflationary policy in an expanding economy.
But, if, as I said, all prices move in accordance, why does it matter? Inflation does not rain on the economy uniformly, it finds its way through the central banks, commercial banks, investment banks, businesses, capital goods. Production is diverted from consumer goods which in turn rise in price. Salaries rise last, interest payments don't rise at all. Inflation distorts the whole structure of the economy.
While there has been deflation recently, it is erroneous to call the fall of stock prices deflation. If I convince myself and everyone that I have an oil field in my garden, and then proceed to dig and find out it's not there, the fall in price of my garden's share is not "deflation".
The monetary level is a simple macro correlation, call it deleveraging or deflation of the monetary mass, it has the same final depressing effect on prices. The sudden movements are dynamics, the equilibrium driven by monetary levels.
Still reading Fisher on money btw, great read, thanks for the recommendation.
Negative on the first paragraph. Have you seen a CPI of -50%? Everyone IS poorer, and if you can avoid the carnage, you should, nay, you must! You are not sounding like a rational automata :)
Pretty much yes. Everyone thought there was solvable demand for a lot of housing and it turns out there wasn't.
The monetary level is a simple macro correlation, call it deleveraging or deflation of the monetary mass, it has the same final depressing effect on prices. The sudden movements are dynamics, the equilibrium driven by monetary levels.
Deleveraging happens for a reason, the assets cash flow cannot pay for the underlying debt.
By the way you're still swamped in your tide metaphor. If all prices indeed lower at the same time, what's the problem? If prices do not fall at the same time, where's the correlation?
As for the first comment, it implies you value status in the eye of others above your own values, which I find slightly evil.
I Blame Markowitz
You don't know me, I don't know you. Manage your money like you see fit and don't throw moral judgments on others.
Ali, thanks for the link, it is a good read. The author seems to have a beef with the religious status of the theory. Efficient frontier is still a valid concept though. I think a lot of people are quite happy putting the nose of the quants to their own arrogant excesses.
I never said such a thing.
I commented on,
"Well, if everything is down proportionally, then you're just as wealthy relative to everyone else as you were before."
by saying I found it slightly evil to find comfort when you lose capital in the idea that everyone else is also worse off. It's a mild form of schadenfreude.
I think one should be concerned with his own happiness, not his relative status. It's a personal philosophy, I did not mean to imply that the poster was himself evil, and I certainly, absolutely, did not say that capital preservation was evil.