While cycles of fear—or the herd instinct-are stronger than cycles of greed—also the herd instinct–though not as strong—both cause correlations to rise. Fear is just a stronger emotion than greed when it comes to correlations. When folks panic they sell without thinking and move to safety.

In terms of diversification and why I think it will lessen we must be clear. There is in my opinion a distinct difference between stock asset class diversification for an all stock asset class portfolio vs. diversification of a portfolio that includes other asset classes. When I say diversification will lessen I am talking about the all stock asset class portfolio—I can’t imagine a scenario where we get the divergences in major asset classes into the future that we have seen in the past. However, I do not believe that diversification will lessen when you include other assets into your portfolio mix such as Bonds—US and Foreign, Real Estate–US and Foreign, Energy, Commodities, Currencies and Alternative Investments.

You are correct in asking about foreign currencies if your question is one about diversification. If you have all your assets denominated in a single currency you are betting on that country doing well and I think that is a mistake.

In terms of diversification math—-I leave that up to you. You can start with the original Markowitz paper and work your way up to the French Fama three factor model—circa 1994. Or you can read French Fama first and then see the sources they cite to teach yourself. I like to learn by working backwards.

In terms of Russell—just go to their site and you will see they have past data available.

In terms of correlations rising—-I do my own research on this. It’s important to recognize that correlations are a function of the time frame you use so be careful. Most importantly—-you can’t trade correlation because it can be misleading. You can have 2 assets that are perfectly correlated and one makes 100% while the other makes 20% over the same time frame. I am far more interested from a profit motivated perspective with looking at price divergence over different time frames.

Your final question is really asking will stock asset classes continue to diverge—-the answer is absolutely without a doubt. I don’t know Buttonwood but I can say with certainty that as long as man measures there will be divergence. We are the markets—-they are not us. We give them life with our opinions as we place our bets. As long as we have different opinions we will have divergence. I suggest you read my white paper Will Asset Classes Continue to Diverge and Converge.

And just on a personal opinion question, why do you believe diversification will lessen? Wouldn’t the dollar appreciaton against foreign currencies prompt people towards MORE diversification of assets, since foreign assets are held in foreign currencies

If you are asking are stock markets more correlated today than yesterday than the answer is yes on the three time frames I analyzed which are short, intermediate and long term time frames. If you ask will stock markets stay at these levels of correlation into the future or will they get more or less correlated–I would bet more or less and if I had to choose one I would bet less. But let’s look at the last few years and analyze.

If you look at long term stock market correlations ( my preferred actionable time frame) for 3 major stock asset classes over rolling 12 month periods you find that the natural divergence then convergence of the past is getting narrower. Stock markets don’t diverge as much as they did in the past yet if you measure the peak to trough divergence you can see there is still plenty of divergence. For example, if you look at the last 12 months of the Russell Large Cap Growth index it has a positive return of about 14% while the Russell Small Cap Value index has one of 3%, while Large Cap International Developed markets are down 5% over the same time frame. This gives you a peak to trough divergence of 14 less minus 5 or 19%. So your blogger friend may be right about markets being more correlated but I would rather focus my attention on having my money and client money invested in Large Car Growth and not in Large Cap Developed. If you add a 4th stock asset class such as Brazil or China they are down about 16% over the same 12 month time frame which is a 30% divergence.

What actually happens is that correlations rise towards 1 when markets are in fear mode such as in February/March 2009 and then start a natural progression back down to a steady state until the next fear cycle. This has been happening since the beginning of time. So if you are asking is there a safe place to hide in the stock market when markets are crashing the answer is no. Every major stock asset index fell over 50% from peak to trough during the Oct 2007 to March 2009 decline. So if you think you are diversifying by owning different stock asset classes you are right——you are not. I repeat—-I see correlations as a fear to greed to fear cycle and not the way most people view it as a new information driven phenomenon. I also see correlations as highly dependent on the time frame you use to measure and would advise you to use only long time frames as measured in years and not minutes or days.

What I espouse about diversification is that everyone must choose to diversify or not as you can read about in A Tale of Diversification. It is the central question or decision you must answer. If you choose to diversify you should also diversify amongst asset classes that don’t have correlations that go to 1 when stock markets are in fear mode. If you pick a an asset allocation of let’s say 60% stocks and 40% bonds and then you re-balance when your allocation to stocks reaches either 66% or 54% you will have satisfactory returns and I suspect out-perform more than 90% of investors on the planet.

I suggest you read my white papers if you choose not to diversify. They will give you insight on ways to concentrate your portfolio in those asset classes that are top performers and avoid those that are laggards. This is just one approach and my preferred approach. There are many others you should examine in your studies. Feel free to keep asking me questions since this is the purpose of this site to promote financial literacy.