Why correlations tend to 1.0

After I finished my book Abnormal Returns: Winning Strategies from the Frontlines of the Investment Blogosphere I began thinking about potential follow-ups. One idea I thought about would explore asset allocation in greater depth with an emphasis on finding asset classes (and strategies) that could provide investors with greater diversification opportunities.

On further reflection it seems that book has in large part already been written by a far more accomplished author. I recently read Skating Where the Puck Was by William J. Bernstein. Bernstein is the author of such well-respected books including among others The Four Pillars of Investing: Lessons for Building a Winning Portfolio, The Investor’s Manifesto: Preparing for Prosperity, Armageddon, and Everything in Between and The Birth of Plenty: How the Prosperity of the Modern World was Created. He was also one of the early adopters of writing about investing on the web with his site Efficient Frontier.

Skating Where the Puck Was* represents the second e-book in what Bernstein calls his “Investing For Adults series. The first book in the series is The Ages of the Investor which is on the topic of life-cycle investing. Bernstein cautions potential readers that these books are “not for beginners.” That being said I think motivated readers can get a great deal out of this quickly read e-book, in part because his thinking jibes closely with mine on a number of topics.

The message of the (short) book is pretty simple. Let’s let Bernstein explain:

In this second e-book, I examine the vicissitudes of diversification in the ever more global capital marketplace, in which correlations trend closer and closer to 1.0. The headlong rush of pension plans, endowments, and wealth management assets into hedge funds, private equity, commodities, and private real estate provides a lens to observe just what transpires when, as almost always occurs with initially good ideas, Wall Street runs it into the ground.

One of the grimmest realities of finance is that as an asset class becomes more popular, it suffers the twin plagues of falling expected returns and rising correlations.  While this booklet offers useful guidance to small investors, its real audience is in the institutional realm, which, without putting too fine a point on it, is headed en masse off a cliff called “The Yale Model.”

Bernstein tackles the subject of why asset classes with seemingly low correlations inevitably become more correlated with the rest of the world as they become more popular and accepted by mainstream investors. This helps explain why the great rush into commodities in the past decade ended in disappointment and how the “ETF-ization of everything” is changing the markets. Bernstein also touches on the topic of the Yale Model, the future of the “permanent portfolio,” “Rekenthaler’s Rule” and where investors should look today for uncorrelated returns.

So the world will not get my book asset allocation, but instead has a concise and clear explanation of phenomena that vexes many investors. The implications of the book are pretty simple: there are no shortcuts to investment nirvana. As Allan Roth at Total Return writes:

In this second installment, Bernstein leaves us with the hard truth perhaps only adults can accept: There is no magic policy rich in high returns and low correlations. He leaves us with a critical finding: “Your long term results are less the return of how well you pick assets than how well you stay the course during bad periods.”

As I say in my book “Investing is an adult responsibility” and most investors would do well to remember there is no such things as magical investment policies as well.

*I read Skating Where the Puck Was for free on my Kindle as a part of Amazon’s Kindle Owners Lending Library program.

See additional coverage of SWTPW:

In Investing, No Need for Sudden Death  (NYTimes)

The Madness of Chasing the Crowd  (Total Return)

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The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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  • Tadas ViskantaAbnormal Returns has over its seven-year life become a fixture in the financial blogosphere. Over thousands of posts we have striven to bring the best of the financial blogosphere to readers. In that time the idea of a “forecast-free investment blog” remains as useful as it did six years ago. More »

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