Korva is a scroll of the internet’s best ideas.
Fifteen uncorrelated return streams
The reason is the math of diversification. Each added stream that behaves differently from the others brings a smaller marginal benefit, and the benefit depends on how correlated the streams are. Around fifteen, risk drops by about 80 percent while the return stays the same.
That raises the return-to-risk ratio by something like a factor of five. In effect it gives the upside without the downside, because the downside shrinks and the upside doesn't.
Bridgewater's record shows what that looks like. It made about 11.8 percent a year for something like 31 years, with returns uncorrelated with the stock market or any other market, and only a handful of years lost money. Losses are costly because a 50 percent loss needs a 100 percent gain to make the money back, so keeping them small lets the compounding run.
Why does mixing streams cut risk so sharply?
When return streams move independently, their ups and downs partly cancel out. With a number of equally risky, truly independent streams, the volatility of the combined portfolio falls in proportion to one over the square root of the number of streams. For fifteen streams that works out to roughly a quarter of the single-stream volatility, which is close to the 80 percent cut described here. The shortcut only holds to the degree the streams really are uncorrelated.
Why do correlations jump in a crash?
Assets that move independently in calm periods often fall together in a crisis. Researchers studying market turmoil, including work on the 2008 financial crisis, have documented that correlations between asset classes rose sharply as investors sold whatever they could convert to cash. That is why portfolios built from streams that behave differently for fundamental reasons tend to hold up better than ones that only look different in quiet times.
How can returns ignore the stock market?
Funds can take both long and short positions across stocks, bonds, currencies, and commodities. Their results then depend on how prices move relative to one another, not on whether the market as a whole rises. A fund that is long in one place and short in another can earn money in either direction, which is how some returns end up with little link to any single market.
More from My First Million
