2008 is a terribly misaligned year. It is the “annus horribilis,” the year everything in finance went wrong. But instead of complaining about it, we should be quietly celebrating it.
There are many reasons to celebrate 2008 — mostly because it highlighted the dangers of everyone slavishly following modern portfolio theory with its deceptively flawed assumptions of constant volatility and correlation. By ignoring what we call “the evil twins” of correlation and volatility, the theory simply ignored grave potential dangers.
The first “evil twin” is volatility of correlation (i.e. the correlation itself is not stable). Just as you can have good and bad cholesterol, so, too, can you have good and bad unstable correlation. We all witnessed bad unstable correlation in 2008. Prior to this, our portfolios looked diversified and stable and we focused on relative risk/returns to generate an efficient portfolio. Then, as the systemic crisis unfolded, hitherto uncorrelated asset returns began to move together, correlations tended to one and the protection promised by traditional diversification, as preached by modern portfolio theory, failed.
But there is a “good twin”: favorable instability of correlation. This is displayed when an asset's correlation tends to -1 (i.e. the more unstable the asset's correlation becomes, the more uncorrelated the asset becomes vis-à-vis the portfolio). This is a very good characteristic as the more negative the traditional asset's performance is, the more positive the uncorrelated asset's performance becomes, therefore providing portfolio protection.