Time-varying correlation - Diversification benefits are dynamic

What is the correlation between two assets? The correlation is critical because it is the driver for any diversification decision. The better question is, "What is the correlation now, and what can it be in the future?". Correlations are often time varying and regime specific. In bad times, correlations rise, so the diversification expected is not present when you need it. This phenomenon requires more thinking about tail risks and how to best address them.

It is not clear that investors fully appreciate the magnitude of the tail problem. Of course, investors have felt the impact in their portfolio returns but visualization clarifies the point. We are using the figures from the Financial Analyst Journal, "When Diversification Fails" by Sébastien Page, CFA, and Robert A. Panariello, CFA which compares the equity left and right tail extremes for traditional assets, hedge fund assets, and investment factors. 

What is truly surprising is the for traditional assets is the magnitude of the differences between the left and right tail. In the case of hedge funds, there is limited diversification safety in the left-hand tail. For many strategies the correlation is as high as what would be expected for a traditional asset. Alternatively, there is much better diversification benefit from investing in factors. A balanced portfolio of factors that can be generated from alternative risk premia is likely to provide a more stable diversified portfolio. 

Market extremes are usually associated with common factor like an economic downturn. For long-only benchmarks, correlations will rise in response to these shocks to market beta. Factor investing identifies and isolates risks which may not be driven by phenomena like growth shocks in the same way. There will still be dynamic changes in correlations across factors during extremes, but these changes may be muted or more independent. By simply changing the type of risks taken, investors can change the diversification outcomes. 

Credit risk - Leverage suggests magnitude of problem not when it will occur

Looking at the current credit situation suggest that many investors confuse the timing of a credit crisis with the potential intensity of the crisis. The timing of the crisis will be defined by a shortfall in corporate cash flow. It could be from a slowdown in growth or any other impairment of cash which changes the probability of debt pay-off. The intensity of a credit crisis will be based on the overall leverage in the economy. For a given decline in cash flow, the severity will be worse based on the amount of leverage. The intersection of these two effects determines the probability of a crisis. As leverage grows, the shock to cash flow necessary to create a crisis declines. An X% decline in cash flow will have a greater chance of creating a crisis when leverage is higher, so any prediction of a crisis is more likely. However, we cannot say when.

Given this environment, the impact of a negative credit event increases on any negative economic news. However, there has to be focus on the where, how, and when. Our simple map displays some of the likely paths associated with a credit crisis.

Behavioral economics - Is an atheoretical approach harmful?

Behavioral economics research has been path breaking and has truly impacted the thinking of most investors. Psychology is fundamental to human decision-making and our knowledge and understanding of economic agents has been enhanced through the large body of research in this area. Through finding exceptions and breaking down conventional utility maximization theory and wisdom, behavioral economic has advanced science, yet this work is not completely fulfilling. Our knowledge is filled with behavioral exceptions and leaves us with the impression that our decision-making skills are psychological damaged, but there is no unifying framework for how the range of biases fits within utility maximization, consumer behavior, market efficiency, and general decision-making. 

My anxiousness is with the atheoretical nature of this work. Research based on exceptions or storytelling is effective at punching holes in existing theory but the broad list of biases has not replaced the current paradigm with a new framework. Perhaps we are still early in the process; nevertheless, the need for a theory/model/narrative construct is all the more important to support the foundation of economics; good theory with testable hypotheses. These points are well articulated by Ran Spiegler in the current issue of the American Economic Journal: Microeconomics, "Behavioral Economics and the Atheoretical Style".

The author contrasts behavioral economics with game theory. Game theory has provided a rich set of theories to explain, test, and predict behavior. A collection of behavioral biases no matter how large cannot replace the existing paradigm of thinking about choice. Any paradigm shift needs a new theory to supplant the old. This is more than an interesting discussion on theory. Investors everywhere know about behavioral biases as lists of bad behavior, but to truly improve behavior, theory is needed to provide a scaffolding to bind our thinking. 

Microcosm versus Macrocosm - The impact of your mental model in decision-making

Every investor has a mental model of how the world works. Some may call this their philosophy. Other will call this their belief system. These mental models form their rational expectations or rational beliefs. They are rational because they are consistent with the mental model being employed. These beliefs should be unbiased. If they are not, it requires the investor to adjust their model to eliminate the bias.  

Pierre Wack, the great scenario strategist for Royal Dutch Shell, would say that that every manager or firm has a microcosm view or mindset while the world and firm operates in a macrocosm. The idea of the microcosm and macrocosm comes from the ancient Greek philosophers who discussed the place of the human beings in the universe. These discussions focused on the place of the individual in the greater cosmos. It fell out of favor with philosophers in modern times.

Differences in corporate strategies will be related to each firm's microcosm. Call it their style and culture. Whether a firm is successful will depend on whether their microcosm can match reality in the world macrocosm. Culture and philosophy trump strategy, but success is whether this style microcosm can map effectively into the macrocosm. The macrocosm is a given. There is no value judgment of it being right or wrong. It is the reality that must be mastered. There is only one macrocosm while there may be many microcosms. The successful firms have the greatest overlap between the microcosm and macrocosm and the will to act on this overlap.