When Assets of a Feather Flock Together

03/28/2007 12:00 am EST

Focus:

John Bollinger

President and Founder, Bollinger Capital Management

John Bollinger, president of Bollinger Capital Management and editor of Capital Growth Letter, shows how portfolio diversification can break down during market sell-offs, when everything goes the same way at once—down.

Harry Markowitz pointed out the benefits of diversification more than 50 years ago and in doing so launched Modern Portfolio Theory and ultimately shared a Nobel Prize with William Sharpe and Merton Miller.

The basic idea is quite simple: by combining dissimilar assets one may improve the risk-adjusted return on a portfolio. MPT is very useful, but there is a problem that is little talked about.

In normal times, well-constructed portfolios do indeed embody very desirable characteristics. However, in abnormal times correlations converge on one and the benefits of diversification vanish.

During the recent market decline, gold, which is usually thought to be a good contra-cyclical hedge (poorly correlated with equities), went down hand in hand with stocks. The central idea here is that when it comes time to sell something, the liquidity may not be there to accommodate your desires, so something else must be sold instead usually what is most liquid and easy to trade.

For example, the 1987 crash started innocently enough, [but] there was a new kid on the block, portfolio insurance, and people hadn't gotten to know him yet. As the market started to decline the portfolio insurers were required to sell and the farther it declined the more they had to sell. Their programs were mechanical, so they just pressed the offers relentlessly lower, creating a feedback mechanism that drove prices down.

At the same time, the popular practice of selling out-of-the-money put options for income was causing trouble in a large number of portfolios. In the 1987 crash, these portfolios became a major source of selling, as anything that could be sold was sold to cover the repurchase of puts that had been sold on the cheap and now had to be bought back at ruinous prices. Faced with what seemed to be a perfect storm generating massive declines, Wall Street firms sold anything they could as well.

To sum up, a storm of selling pushed all correlations to one and everything went down together. Of course, 1987 isn't the only time this has happened; it is actually a fairly common occurrence.

Speaking of "perfect storms", the recent wave of volatility in the world's equity markets caused a slight realignment in our allocations.
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This correction began in China and it has impacted the international markets more than it has the US market. Consequently we reduced the allocation for international stocks from 25% to 20%. We plan to put this money back to work in US stocks.

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