It´s the correlation, stupid
A fund industry mind trap? (Or the weakness of averages)
Diversification; let´s say you have an equity index investment. Now you would like to add another asset to it. What would you rather prefer; An asset A with a correlation of 12% or an asset B with a correlation of 18%?
If you say A and 12%, what if I tell you that asset A has a constant correlation during upmoves and downmoves in your equity index while asset B has a negative correlation on downmoves and a positive correlation on upmoves?
Sensitivity analysis is crucial whenever talking about correlation. Although this is quite fundamental it still slips through when seeking alpha and total returns.
Once a theory has been accepted, it rarely becomes questioned again. As humans seem to be more apt to consensus and linearity than they would perhaps like to admit. So are the common perceptions of risk, growth, inflation volatility and future outlooks.
Right now, it is easy and human to think linear about the future. However, this is rarely the case. It more often than not becomes drastically different. If leverage, misallocation and financial market functionality restraints are any variables to go by, I´d say the likelyhood of linearity going forward is more redundant than ever during the last 60 plus years.
In other words; Be an optimist, but; Hope for the best but prepare your riskmanagement eventualities for the worst.
