Factor Investing and Dumb Investing

Good data from the WSJ. Unfrotunately, it reaches the wrong conclusion. There is no reason to believe that because correlation is high for a few months

Cover of "The Intelligent Investor: The D...

, that it will last forever.

Below is a quote from an article by Jason Zweig in the WSJ(Nov. 2011)


According to data from MSCI, which tracks stock indexes around the globe, the average monthly correlation of the U.S. with the other countries in the MSCI World Index is 0.80—not far from the maximum 1.0. But at the end of April, days before most stock markets peaked world-wide, that relationship stood at 0.81. At the end of last year, it was 0.82; in March 2009, it was 0.87. Over the past 10 years, it has averaged 0.78.

Correlation is not that much higher today, and even at the current level of 0.86, will likely go down again.

Furthermore, one has to be crazy to change their investing style based on a few months of returns. If you consider yourself a value investor and are itching to switch your style, go back and read the Intelligent Investor. If you are not a value investor, what I say will likely be unconvincing regardless. However notice how the article tries to convince people of the EMT. If you are a believer in it, this is a good site to read-

Without further to do:

The drama in Europe is putting the best-laid investing plans to the test. Each day, it seems, stocks are either soaring (“risk on”) or plunging (“risk off”)—yet for the year the Dow Jones Industrial Average has barely budged.

The main culprit: “correlation,” or the extent to which assets move in unison, which reduces the benefits of diversification and limits investors’ ability to control their portfolios. According to Birinyi Associates, the correlation between the stocks in the Standard & Poor’s 500 and the index itself rose as high as 0.86 in October—nearly a perfect 1.0—from as low as 0.4 in February.

But don’t despair. By changing the way you spread out your stock holdings, you can reduce risk and boost returns—even in a highly correlated market like today’s.

The trick? A concept known as “factor investing,” which originated in academia two decades ago and now is finding favor among institutional investors and high-end financial advisers.

Factor investing replaces traditional asset allocation—such as a portfolio with 30% in U.S. stocks, 20% in developed international markets, 10% in emerging markets and 40% in bonds—by focusing on specific attributes that researchers say drive returns. These “risk factors” include the familiar—like small versus large-size companies or growth versus value stocks—as well as more esoteric measures such as volatility, momentum, dividend yield, economic sensitivity and the health of a company’s balance sheet.

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