When Diversification Fails – How the ‘Only Free Lunch in Investing’ May Not Be So ‘Free’

By Sébastien Page, CFA and Robert A. Panariello, CFA of the CFA Institute: Financial Analysts Journal

Diversification can fail: “We recommend that investors avoid the use of full-sample correlations in portfolio construction— or, at least, that they stress test their correlation assumptions,” from the Financial Analysts Journal.

"One of the most vexing problems in investment management is that diversification seems to disappear when investors need it the most. We surmise that many investors still do not fully appreciate the impact of extreme correlations on portfolio efficiency—in particular, on exposure to loss. We take an in-depth look at what drives the stock-to-credit, stock-to–hedge fund, stock-to–private asset, stock-to–risk factors, and stock-to-bond correlations during tail events. We introduce a data-augmentation technique to improve the robustness of tail correlation estimates. Finally, we discuss implications for multi-asset investing."

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When Diversification Fails – How the ‘Only Free Lunch in Investing’ May Not Be So ‘Free’

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