Correlation Confound (Part 4)

Today I continue by bringing optionScam.com into the discussion.

“Correlation,” “diversification,” and “pairs trading” are significant buzzwords for the financial industry.  The former is a buzzword used as a tool to achieve the latter two. The latter two are buzzwords for minimizing loss, sleeping well at night, and profitability.

It’s all good!

I wonder how much product, in terms of AUM, has been sold based on the advertising of “portfolio diversification?”

I wonder how much product, in terms of investment newsletters, trading services, and educational seminars, has been sold based on the advertising of “pairs trading?”

I would guess most of the advertising for either has made use of correlation and charts/tables to argue its efficacy as a profit-generating tool.

The story is usually incomplete, however, and this is where advertising becomes optionScam.com.

Correlation confound #1:  correlations based on historical price changes can and will change in the future.   The industry advertises diversification as having the potential to improve returns for a particular level of risk you choose based on your goals, time horizon, and tolerance for volatility.*  If I think I have achieved diversification by including noncorrelated assets in my portfolio then I may be surprised when the next market crash hits and all correlations converge to +1.0.

Correlation confound #2:  I thought I had good pairs to trade since they met the criteria for correlation but nobody told me about cointegration.  The concept of pairs trading is a very marketable idea because it makes sense that following divergence, two markets tending to move together will snap back toward each other like a stretched rubber band after release.  The problem is that correlated markets can move together but still, over time, be moving apart. Pairs trading without cointegration will be a losing proposition.

Correlation confounds can be optionScam.com when I make less money than expected or even lose money while somebody else is making money off me.

*—to be addressed in the next post