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The Problem With Numbers

April 15, 2024 | Posted in: Insights

Most MBAs undergo a heavy dose of quantitative training which leads them to believe they can figure out the financial world using sophisticated analysis. While ratios, formulas, and statistics can indeed be helpful, there is a fundamental problem-numerical relationships change. One of the benefits of the classic “balanced” portfolio of 60% stocks and 40% bonds is that stocks and bonds do not move exactly in tandem which means that including both should reduce overall portfolio volatility. The relationship between the returns on any two investment categories is measured by the correlation coefficient which ranges between plus and minus one. A reading of 1 means that the two categories move exactly in tandem, -1 suggests they move in the opposite direction, and zero indicates no relationship between the two. Well, here is the three-year rolling correlation between stocks and bonds since 1871:

Note that the relationship has been both positive and negative so the value of bonds as a diversifier has varied considerably over time. The reality of positive and negative swings in correlation is that it is difficult to model the future behavior of even a simple portfolio. Multiply this problem by the seven to ten asset classes included in a diversified fund and you have to conclude that portfolio structuring is an inexact science. Even using the best tools available, we are sure to get surprises such as 2022 when stocks were down 18% and bonds failed to provide much cushion falling 13%.