9
Correlations and Something About a Freezer and an Oven1
Let’s not forget that the quality of a model must be compared with another model. The best model is the one that leads to better decisions.
—JPP
WHEN WE FORECAST RISK AT THE PORTFOLIO LEVEL, WE must estimate correlations, either directly or indirectly. The concept of diversification is at the core of every asset allocation decision. It’s the key premise and goal of portfolio construction. The lower the correlations, the better the diversification, and if we hold everything else constant, the higher the risk-adjusted return.
Yet one of the most vexing problems in investment management is that diversification seems to disappear when investors need it the most. Of course, the statement ...
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