When Diversification Fails

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In their report, authors and T. Rowe Price portfolio managers, Sébastien Page, CFA, and Robert A. Panariello, CFA state, “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.” 

They recommend, “Prudent investors should not use them (correlations) in risk models, at least not without adding other tools, such as downside risk measures and scenario analyses. 

To enhance risk management beyond naive diversification, investors should re-optimize portfolios with a focus on downside risk, consider dynamic strategies, and, depending on an aversion to losses, evaluate the value of downside protection as an alternative to asset class diversification.” 

This table illustrates their findings. 

Image

The general shakiness of the asset class correlations' relationship suggests that asset allocation recommendations and products ought to respond to changes in the economy and the market. 


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