The Myth of Diversification

Abstract

Perhaps the most universally accepted precept of prudent investing is to diversify, yet this precept grossly oversimplifies the challenge of portfolio construction. Correlations, as typically measured over the full sample of returns, often belie an asset’s diversification properties in market environments when diversification is most needed. Moreover, upside diversification is undesirable. The authors first describe the mathematics of conditional correlations assuming returns are normally distributed. Then they present empirical results across a wide variety of assets, which reveal that, unlike the theoretical conditional correlations, empirical correlations are significantly asymmetric. Finally, the authors show that a portfolio construction technique called full-scale optimization produces portfolios in which the component assets exhibit relatively lower correlations on the downside and higher correlations on the upside than mean-variance optimization portfolios. <bold>TOPICS:</bold> <ext-link>Portfolio construction</ext-link>, <ext-link>quantitative methods</ext-link>, <ext-link>portfolio theory</ext-link>