Why Correlations Will Go To 1
During a market crisis correlations between assets go to 1. Why?
During a market crisis correlations between assets go to 1. Why? Investors might be surprised to learn that it’s by design. To manage risk, more and more Risk Management procedures are put in place but it may well be Risk Management procedures themselves that are to blame.
Uncorrelated assets smooth the volatility ride
When investment assets move in different directions by different amounts at different times under different conditions they are said to be uncorrelated (or less-than-correlated). They don’t move in lockstep 1 to 1. Some Zig while others Zag. And the investor’s diversified portfolio overall has some down-market protection. Think stocks down but bonds up while real estate stays flat, for example.
But that’s not what happens
Somewhere a trigger gets pulled and in a rush to exit panicky markets, market players stampede. Mass selling causes prices across markets to be driven down. Everything moves together. Everyone wants cash. Royal Bank equals CIBC. IBM equals Microsoft. Correlations go to 1.
Risk Management to the rescue
There are umpteen notable disasters that have triggered panicky markets. In response, Banks and Financial Institutions in general have turned to Risk Management. Louder shareholder voices demand it. Regulators require it. Today all Banks and Financial Institutions have some form of Risk Management infrastructure. Risk protocols stretch from the Board level down to operations and procedures.
Herein lies the problem – There is less separation
As Banks and Financial Institutions participate in a globally intertwined world, they participate in like markets utilizing like financial instruments and hold like positions. Not the same but similar. Regulatory requirements and industry best practices dictate that the Risk Management infrastructure overlay is similar too. And all risk management involves measuring correlation.
At the corporate level to the line of business level on down to the departmental level, similar methods and models are used to allocate risk limits to the individual trader level. This prevents concentration of risky-beyond-risk-appetite positions while still allowing for trader flexibility to express their market opinion.
But similar models will send out similar signals at similar times based on similar triggering events. When adverse conditions happen, positions may move beyond set limits. Trader compliance means a trader may have no choice but to liquidate positions to bring themselves back onside. In August 1998, widespread efforts to liquidate broadly similar positions in roughly the same set of markets seem to have intensified the adverse movements that were the initial problem. Traders form a dog-pile at the exit. Prices get driven down. Correlations go to 1. Zig equals Zag.
Not only is risk management regulated externally and managed internally, Trader compliance is simple self-preservation.
Smart investors know that when the market correlations go to 1 is when opportunity presents itself. Prepared value-buyers can take advantage by knowing in advance what they want to buy and at what price and always have cash on hand.
_____________________________________________________________________________________Next time? More Risk Management. Doug Cronk CFA is a Pension Investment Officer