Dr CKN's Blog

The Investment Process Is Broken
Or, Why volatility has gone up in all asset classes.

Many weeks ago, I wrote an article on the site on the increased volatility in different asset classes (see High Volatility Readings are here to stay ). In that article I had discussed how volatility readings had increased across the globe and across asset classes. Several reasons were discussed and one of the conclusions was that higher volatility phases are here to stay.

In the last week I came across this article studying the correlation between asset classes in the pre and post Lehman days. I thought it was very interesting and an absolute explanation for the increase in the volatility. Take a look at the two diagrams below. These are courtesy of HSBC and it is a RiskOn-RiskOff matrix that they have created. I believe it explains the increased volatility concept that I have dealt with in the earlier article rather well.

In the second picture you can clearly see how more of the asset classes have become correlated in the post Lehman area. This means (and this is also the HSBC conclusion) that with so many assets now moving in tandem, the whole investment process is broken.  Fund managers are now acting in concert across multiple assets as they fear contagion from one asset class to impact the returns in other asset classes. Their response to events in one asset class is no longer restricted or confined to action on that asset class alone but is now spreading to other asset classes thereby creating concomitant moves in them as well. Thus the well known ‘butterfly effect’ which most of us thought was all theoretical is indeed becoming true in the current times.

For those who are a bit challenged about what is depitcted in the charts above, a simple color coded explanation may perhaps be in order. Note that in the first picture, you see a lot of green and now check the sidebar – which is a correlation meter. The green is in the center at readings around 0 which means that assets are minimally correlated. At +1 the correlation is high and at -1 the correlation is inverse.  Now check the picture two and note how the green shading has all but disappeared from the picture. Much of the picture is now either leaning towards red or blue meaning there is some correlation that has got built across all asset classes and across the globe.

The financial world as we knew it, has changed in character and complexity forever. If we do not change ourselves to accept this new reality and raise our own skill levels to deal with the newer ramifications that emerge out of this changed reality, we shall soon become a wayside statistic.

Arise. Awake. Act.  Those are the three words spoken by Gurudev Swami Chinmayananda in a spiritual context. It is so true also now under the financial context!