Justin Lahart in the Wall Street Journal reports some shocking statistics from Rich Berstein at Merrill Lynch. The statistics show a marked increase in correlations across nearly every asset class over the past five years.

Even current darlings, hedge funds, are shown to have a high correlation with the stock market. One explanation is that these very hedge funds have been forced to spread their bets across a variety of asset classes, thereby pushing correlations up.

Correlations in general fall during bull markets. It is during bear markets when you expect to see correlations rise. And in the case of a crash, correlations often push to near unity as investors flee all risky assets.

Does this call into question the wisdom of portfolio diversification? Not really. Any one with a historical perspective beyond a year or two will realize that this phase will end eventually. The only question is what causes a decoupling in asset class correlations. Lahart insinuates another market break would do the trick:

The danger is that if one asset runs into serious trouble — or if the cash hoard dries up — trouble could quickly spread to other areas. "Everybody would end up plowing out of the same things at the same time," Mr. Richards says. Then, correlation would translate into another C-word: contagion.

One of the upsides of the ETF boom has been that it provides investors with a wider array of instruments from which to pick. That includes both on the long side, and the short side (if you can find the stock to borrow). Despite recent historical returns it remains a good idea to maintain more diversification over less diversfication. Let's hope we don't have to learn that lesson the hard way.


Image source: WSJ

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