I recently posted this table of index price correlations.
Its a fairly simple table that looks at the degree to which indices follow one another in their general pattern of movement. As you would expect indices that are closely related share a very high correlation. For example the Dow and the S&P500 share a price correlation of 0.97 which is almost perfect. The natural expectation would therefore be that the returns from these two indices would be the same – investing in one would be as good as investing in the other. However, when looking at price correlations things become a little more complicated. The chart below looks at the value of $1 invested in both the Dow and the S&P500 starting just before the GFC hit.
As you can see there is a constant dislocation between the two. Price correlation and return correlation are not the same, in this instance the return correlation is a few points lower. To make matters more complicated all correlations are influenced by the time period you are looking at. The chart below looks at the value of $1 invested in the All Ordinaries and the Dow over the same time period.
There is a marked difference between the performance of the Dow and the All Ordinaries yet, according to our correlation table the correlation sits at a very high 0.74. What you think you see is not what you get – simply overlaying one price chart over the other would not have highlighted the significance of this difference. But this relationship is affected by the time period selected. The chart below starts much earlier and ends just before the GFC.
As you can see the situation is reversed with the local market belting the Dow. It is obvious that over different times different markets will display different returns and that this difference is not a function of their price correlation. This presents a series of conundrums for investors in terms of which market to pick to invest in and it also causes problems for the notion of diversification. With regard to the problem of which market to pick this can be solved relatively easily by looking at the relative performance of markets on a regular basis. This is actually quite easy to do since both Yahoo Finance and Google Finance offer a comparison function in their very basic charts.
The notion of diversification is a harder nut to crack. Diversification in the sell side of the industry is based around the idea that if things have different names then you are diversified. But this is a simplistic interpretation as you can see simply by looking at returns. It is possible for instruments to have different names but similar returns and if that return is negative then simply picking instruments on the basis of their name is flawed. To give you an insight into the issues that arise from looking too deeply at diversification consider the table below which looks at the differences in the price and returns correlation for the four major local banks.
As you can see the correlations are strong but quite different. If you were to pose the question as to whether the returns from all the local banks would be the same most would answer yes. Yet this answer would be wrong. In answering the question on diversification I have to admit a personal bias – I do not believe in traditional diversification for the reasons outlined above but also because I operate on a different philosophy. I only have a limited number of good ideas and if those good ideas share similar names then I will probably buy all of them. This as you would expect does introduce volatility into the returns as it sometimes goes wrong but it also sometimes goes right.
This does raise the issue of whether this is more of an academic interest rather than a practical one for traders. The issue of being in the right market at the right time is certainly a practical issue as local stock traders have largely been wasting their time since the GFC. The real gains in equities have been in the US as it has enjoyed one of the largest bull markets in its history whereas we have gone sideways with the occasional burst of short lived excitement. With regard to diversification I am ambivalent.
For my own curiosity I decided to have a quick look at the price correlations of a handful of world indices. Those correlations that are below 0.5 I have coloured red.
As expected most share a positive correlation with the only true diversification coming from the Shanghai Composite. This does pose a conundrum for index traders since it causes difficulties with diversification in the traditional sense. However,these are price correlations not return correlations. If I get some time I will redo this as returns table and see what the difference is.
If you are a fan of human history the impression you get of our progress over the years is a relentless march forward. We evolved on the plains of Africa as small and weak primates with very little to distinguish us from other animals. Deep time and the relentless random pressure of evolution changed that by giving us a big brain and a wonderfully articulated hand. Our history is littered with people who took those advantages and did remarkable things. In fact history gives the impression that we all strode gloriously towards the future with linked arms singing Do Your Hear The People Sing from Les Miserable.
But this view is totally incorrect, a few people have dragged the rest along for the ride. If it was up to the majority of people we would probably still be sitting on our arses hitting each other on the head with sticks in much the same way that our primate cousins still do. The default setting for humans is one of apathy, this apathy is also a function of our evolution. We evolved to operate in a minimum energy or ground state. That is apply the least amount of energy to something to get by or if you are being technical maintain homeostasis. It is a powerful strategy and it has worked remarkably well but it is also the root cause of much of our dissatisfaction with life and with ourselves since we have two competing trains of thought. The first tells us we should get going and do something and the second in the great Australia Day tradition simply says…ah I cant be fucked…..
And guess which one wins most of the time? Hence we spend a lot of our time in pain.
The interesting thing about this conundrum is that most can get through life doing the bare minimum that society expects. That is go to school, get a job, raise a family but if we are faced with making a change as to who we are or the absolute direction of our life then we baulk at the effort required. We baulk because change requires energy and it is not just physical energy, most can manage getting out of bed but changing the way you see yourself, the world in general or your place in the world is both extremely hard and also sometimes distressing because we have to acknowledge our own failings. As a result we tend to stay in our own neat little orbit because these orbits are comfortable and we don’t really need to do all that much to maintain them. Society even goes out of its way to accommodate our own inertia. When I first started training in a serious way many decades ago it was accepted that to transform your physique would take a year or so of hard work. Over the decades this time has gradually come down and now one of the gyms I frequent is offering a 9 week transformation program because 12 weeks was just too long.
Lost in my own personal history I once heard the phrase you are where you are because that’s where you want to be and if this phrase makes you uncomfortable or you rail against it then it is probably true.
IN THESE UNCERTAIN economic times, we’d all like a guaranteed investment. Here’s one: it pays a 24-cent dividend every four weeks for 60 weeks, 15 dividends in all. Then it disappears. Unlike a bond, this security has no redemption value. It simply provides guaranteed dividends. It involves no tricky derivatives or unknown risks. And it carries absolutely no danger of default. What would you pay for it?
Before financially sophisticated readers drag out their calculators, look up interest rates, and compute the present value of those future payments, I have a confession to make. You can’t buy this security, and it doesn’t really pay dividends every four weeks. It pays every four minutes, in a computer lab, to volunteers in economic experiments.
For more than two decades, economists have been running versions of the same experiment. They take a bunch of volunteers, usually undergraduates but sometimes business people or graduate students; divide them into experimental groups of roughly a dozen; give each person money and shares to trade with; and pay dividends of 24 cents at the end of each of 15 rounds, each lasting a few minutes. (Sometimes the 24 cents is a flat amount; more often there’s an equal chance of getting 0, 8, 28, or 60 cents, which averages out to 24 cents.) All participants are given the same information, but they can’t talk to one another and they interact only through their trading screens. Then the researchers watch what happens, repeating the same experiment with different small groups to get a larger picture.
More here – The Atlantic