Okay, don’t panic! I know the title just freaked you out a bit, but it’s a fairly simple subject up for discussion in this article. First, a little background. Years ago, during my investment banking and product launching days, I used to go around the country with a tremendous economic genius, David L. Smith. His contrarian perspective served him and those he advised (myself included) well. One of the best phrases he coined was “demon extrapolation”. Ominous sounding, yes, and intentionally so. It means that people generally expect their immediate past experience to be their immediate future one. It’s akin to driving while looking only in the rear view mirror – you’ll inevitably miss the upcoming curve and fly off the cliff!
Basically, human beings are hard-wired to be bad investors. Our ancient brains are coded with fight or flight responses for every moment of stimuli around us. All the centuries of yoga and meditation haven’t led us yet to an investing nirvana. Dr. Smith’s “demon extrapolation” is a succinct commentary on how investors will assume that recent past events in our capital markets will continue into the indefinite future – bull markets will get too exuberant, bear markets too depressed, and both are wrong. Markets cycle from high to low valuation routinely, though we will not know or be able to forecast the precise timing of the market’s ebbs and flows. Right now, I believe that global market participants are assuming that stock market correlations are locked in a “known” zone. But, I totally disagree.
The Vanguard Group published a great report on this subject several years ago. I’ve highlighted two of their charts that sum up the reality of how significant asset class correlations can change over time. Using historical asset correlations to construct portfolios is what most portfolio managers do, but it doesn’t mean it’s the best way to do it. The best method would be to develop forecasted correlation changes.
In the chart above, the correlations between US stocks and bonds are illustrated against other asset classes across a 20+ year period. Over such long period (1998-2011), US stocks held varying levels, but all of them were moderately positively correlated within a 0.75 to 0.10 range.
In the chart below, we see quite different correlation data that occurred from October 2007 to February 2009. US stocks were highly positively correlated with several market segments, ranging from 0.95 to 0.30. What this means is that just when you needed the benefits from “diversification” most, it abandons you, in favor for blood-in-the-streets panic.
Pay extra close attention to what your portfolio assets are saying their correlations are relative to one another. Then, ask yourself (or your professional financial advisor) if such a relationship will continue into the indefinite, uncertain future. If you think “yes”… Just remember to consider the demon extrapolation before getting to comfortable.