“On average, I feel great!”
In the investment business, tail risk is persistent and always present. If you look at the distribution of correlations between asset classes, you’ll see some pretty fat tails. The averages of these correlation distributions are used in the construction of multi-asset portfolios. We rely on diversification among these non-correlated asset classes to protect our portfolios when stress hits the financial markets. But too much dependence on the diversification effect may put assets at risk as fear and panic are much more contagious than optimism
Kahneman and others have described how investors experience the pain of losses more strongly than the pleasure of gains. This results in investors (and advisors) reacting much more strongly to bad news than good. It is human nature for investor sentiment to play a role in the behavior of markets. In normal markets, not everyone agrees on fundamental factors such as earnings growth, sales growth and various other valuation metrics. Market ups and downs illustrate the difficulty in forming a broad market consensus. But during financial crises, investors are united in the actions they take. They sell regardless of the fundamentals that had previously driven their buying decisions.
Modern Portfolio Theory (MPT) is based on the correlation between asset classes, allowing investors to hold non-correlated assets that will help to enhance returns without taking on any additional risks as measured by standard deviation. But, as we have seen far too often, fear is contagious. When fear hits the financial markets, correlations tend to rise toward one and all asset classes move in unison except for one. Many studies have shown: when market sentiment turns south, and fear is prevalent, duration risk may be the only “true source of diversification in multi-asset portfolios.” The Great Recession proved this correct. It will be proven correct again. Historically, duration risk comes only in the form of government bonds, not something I hear recommended much these days. Relying solely on diversification to protect portfolios during the next crisis may be unwise. Taking actions such as buying options and implementing dynamic hedging strategies will help overcome some of the shortcomings found in diversification. Yet diversification remains the “one free lunch” in the market today and abandoning it would not make sense as it does work extremely well in normal markets. Thinking about the next “fat tail” event is prudent. Having a rational and exercisable plan will help protect portfolios from the shortcomings of diversification.
SCI HIGHLIGHTS
SCI Monthly Webinar
OUR NEXT SESSION:
TUESDAY, OCTOBER 9th
@ 12:00 PM CDT
In our next session, we will speak to Billy Hwan of Parnassus Investments.
Mr. Hwan is the Portfolio Manager of Parnassus Endeavor Fund (PARWX), a fund currently held by all SCI models.
Join Jim Baldwin and Bob Dunne on October 9th @ 12:00 PM CDT for another great conversation with an industry leader.
Click here to join the SCI Monthly Webinar
Meet Dr. Ken Sleeper
from Ocean Park Asset Management
You’re Invited!
FRIDAY, OCTOBER 12th
@ 10:00 AM CDT
LaSalle St. Securities Home Office
940 N. Industrial Dr. Elmhurst, IL 60126
Dr. Ken Sleeper will be visiting the LaSalle St. Home Office to discuss the Ocean Park Strategic Income Strategy, fixed income investing in today’s markets and the advantages of Post-Modern Portfolio Theory.
Come discuss your asset strategy options with an industry leader!
LaSalle St. Investment Advisors, LLC
940 N. Industrial Dr.
Elmhurst, IL 60126
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