A vast body of knowledge and a wealth of historical data of financial markets support the all-time notion in investments: do not put all your eggs in one basket. Indeed the number one rule in investment management is diversification. The critical question is which baskets to choose, how much to put in each basket and when is the right time to switch between baskets.

The technical term that envelopes all of these decisions is ‘asset allocation’ – that is, the practice of apportioning an investment portfolio across asset classes. The categorisation of asset classes may take various forms, however, the broadest form would include: cash, bonds, equities and alternative investments. Alternative investments may include hedge funds, commodities, real estate, private equity and other non-traditional investments.

The combination of these asset classes in a portfolio is where the benefits of diversification start to arise and where the main aim is to arrive at an optimal mix that minimises the risks and maxi­mises the returns. While there are risks that cannot be diversified away, when two investments that do not move completely in tandem (i.e. not perfectly correlated) are combined, the expected volatility of the portfolio is re­duced. In fact, the less correlated the various asset classes are, the higher the diversification advantage of the portfolio.

The problem with this recipe is that correlations are not static. They change. Various market forces alter the path of each asset class, and the interdependencies, or lack of, across asset classes also change, thus resulting in changes in correlations in different market environments.

The dynamic nature of correlations have been increasingly studied especially in the aftermath of the 2008 financial crisis, which saw the correlations of various asset classes rising higher to the detriment of diversified portfolios. Research has focused on understanding conditional correlations or tail correlations, which is the study of correlations of asset classes in extreme market environments.

The results show that correlations change significantly during periods of market stress and periods of market rallies. They tend to rise in market sell-offs and de­crease in market rallies. This asymmetry is, in fact, the opposite of what investors want. In down markets, investors want diversifiers to protect their losses, whereas in up markets, investors want less diversification to magnify profits.

Other findings show that the correlation between bonds and equity markets increase during bond market crashes, which corroborates the previous re­sults. On the other hand, bonds tend to be less correlated to equities during equity market crashes, which is synonymous to safe haven flows in stock selloffs.

What these findings mean is that neutral or classic measures for correlations are not suitable or reliable to arrive at the optimal mix of asset classes when constructing an investment portfolio. These results call for practitioners and investors to reassess their asset allocation models and adopt an optimisation approach that is more conscious of tail risks.

In the current market environment where central banks are looking at increasing interest rates while numerous investment banks warn of high valuations in equity markets, the likelihood that higher rates and higher inflation will pull down bond markets as well as equity markets is in­creasing. This possibility can make significant damage to supposedly diversified portfolios.

With the use of scenario ana­lysis and stress testing, practitioners can better understand the potential losses of conditional correlations in such market scenarios. Moreover, through analysing downside risk measures at decision stage, asset allocations may be recalibrated to enhance loss protection when portfolio diversifiers break down.

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The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.

Matthias Busuttil is Senior Portfolio & Investment Manager at Curmi &  Partners.