Jan

25

The fundamental theory of asset allocation/ risk management is that diversification (increasing the number of assets invested in) decreases the total risk. The amount of the decrease is generally reckoned solely based on the correlation of the new asset to the total portfolio and the weight given to the new asset. The specific risk is assumed to go to zero as you increase the assets.

However, what if the asset added is poison… such as subprime? What happens is risk is raised not lowered no matter how small the amount added. Its total negative risk. or: The vol rather than lowering is raised, or the square root of -1 cancels the negative to positive.

Likewise for time, in most instances Vol(2t) = 2^1/2 x Vol(t). It is less than 2 X Vol(t) since the autocorrelation is assumed zero.

But what if the vol of one of the time periods is poison, such as on Rogue MLK Monday. The Vol adds to, not decreases, proportionally to time.

I will leave it to the reader to deduce what determines a "poison" time period and asset class… but I would suggest fraud seems to me to be the reoccuring theme, in both my examples.


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