Monday, October 27, 2008

Diversification Jive Turkey Madness

Diversification Jive Turkey Madness or 'when putting all your eggs in different baskets is a bad idea, because all the baskets are sitting in the kitchen of the Titantic'

MBA Nerd Material Alert

So I found this interesting paper that describes situations where diversification will totally pwn you. This article describes situations where increasing the number of items in a portfolio actually increases the portfolio risk. Pretty interesting but a VERY dense if your not into this sort of thing.

On another thought, thinking of the classical view of the portfolio which includes a correlation component. It is quite interesting because diversification makes sense if your 'intra-portfolio correlation' is below 1. So anything below 1 lets you minimize the aggregate risk to the portfolio. Another thought is that the correlation between your portfolio pieces also changes over time, so what had low covariance matrix today may not have low covariance matrix tomorrow. I remember reading somewhere that 'when things start to go down the tubes... things can get highly correlated very fast...' I think I heard a guy on NPR say something to the effect that blind diversification is bad.. kind of like talking on your cell phone while driving while listening to music does not reduce your chance of getting into a car accident =p

I also found this paper detailing the effect of Heavy Tailed returns on popular Risk Measures... To measure and manage market risk, it is important to use a model that describes asset returns accurately. Most financial concepts that have been developed in the past decades rest upon the assumption that returns follow Gaussian, bell-shaped distributions. However, evidence from the markets shows that the distribution of returns in several asset classes diverges from the Gaussian assumption. In particular, it has been observed that the profit/loss distributions present asymmetries and heavy tails. Extreme events, such as large losses or gains, occur with a higher probability than the one implied by the Gaussian distribution

Here is some more epic distribution goodness

An excerpt from one of the papers cited by this link

Positive returns have less impact on future variances and correlations than negative returns of the same absolute magnitude, although the economic importance of this asymmetry is minor. Finally, there is strong evidence that equity volatilities and correlations move together, possibly reducing the benefits to portfolio diversification when the market is most volatile.

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