I came across this interesting paper (which can be found here) the other day, regarding uncorrelated returns.  The basic premise of the paper was that there is no such thing as uncorrelated assets.   The author conveniently cherry picks the last 36 months to prove his point.  Of course the last 36 months can easily be described as unique if not an outlier.   Many have been quick to come to the conclusion that the last 36 months not only disprove the efficient market hypothesis, but also disprove the theory of uncorrelated assets.  This is highly flawed in my opinion.

Let me begin to dissect this issue from the beginning (without getting bogged down in too much mundane theory).  Anyone who is a regular reader has likely taken the time to read the “about us” section on the site.  If so, you know that my investment theories aren’t just some cookie cutter “fill the  Morningstar box” approach.  I believe the efficient market hypothesis is one of the greatest tricks ever played on the investment community.  Any market is nothing more than the summation of the decisions of its participants.   Markets, by definition are highly complex dynamic systems that are susceptible to chaos.  To assume that the summation of these decisions is somehow efficient would mean that the decision makers as a whole are efficient.   While this might be true to some extent, human beings (and even the algorithms written by humans) are guaranteed to be inefficient decision makers in a chaotic system.

The investment world is the civilized version of natural selection.  It cuts to the core of every emotion imaginable.  When Joe Schmo goes to work for 25 years straight in an attempt to create a better life for his family and suddenly sees his life’s savings going down the tube because Lehman Bros went bankrupt you can’t possibly expect him to react rationally in such an environment.  This is no different than the man whose family is attacked in the middle of the night.  Do you expect that man to react rationally when everything he lives for is suddenly in harms way?  Do human beings make rational and efficient decisions in chaotic scenarios?  Even more important, will 1 million humans working in tandem make efficient decisions all within the same system?  No, the majority of them will make highly inefficient decisions.  “Mistakes” as we like to call them.   We all make them.

If we have learned anything over the course of the greatest mean reversion in stock market history over the last 24 months it is that markets are HIGHLY inefficient.  Why?  Because the humans that write the algorithms are using flawed theories and the emotions upon which these trades are placed are not psychologically efficient.  But does this mean the market is so inefficient that there are no negative correlations?  This delves into a much deeper and more important question for this is where the holy grail of investing lies – the all important land of high risk adjusted returns.

David Swensen and the other endowment fund managers were famous for creating high risk adjusted returns using a portfolio of highly diversified uncorrelated assets.  The theories and strategies appeared to work for years and then – poof – it just stopped working in 2008.  What happened?  Was it due to inefficient markets or are there simply no uncorrelated assets?  The answer to this question is far more complex than I can answer in the short space here, but is likely simpler than some might assume.  It is not that there are no uncorrelated assets, but simply that the correlation between assets are constantly changing.

Too many investors like to think that there is one holy grail approach to investing.  Some believe it is buy & hold, others believe it is long only.  The truth is, the investment environment is ever changing.  Buy & hold will work great in some environments and will fail miserably in others.  At the March bottom when I was telling people to buy stocks for the first time in 2009 everyone was saying buy & hold is dead.  I said:

“Unlike the legions of investors who have proclaimed buy and hold dead, I actually believe it is more viable than ever right now”

Although I had been against buy and hold for several years the macro environment had changed so drastically that the period of early 2009 actually favored such a strategy.

The investment world is in many ways similar to a battlefield.   No battle is ever the exact same.  No investment environment is ever the exact same.  A cookie cutter approach is guaranteed to get you killed.  This is why the investment world requires a great amount of flexibility and unbiased thinking.  This is one of the reasons why the comparisons to 1930 are ludicrous.  This environment is its own unique environment.  It is about as similar to 1930 as H1N1 is to the common flu.  Fine for simple comparisons, but upon closer inspection – ENTIRELY different.  Investors who believe they can apply one approach to all market cycles and expect to deliver above market returns are fooling themselves.  Like a strain of the flu, you must attack that particular flu virus with the correct anti-virus.  Likewise, each market requires a different battle plan.

Traditionally, the investment community has believed that real estate, private equity and hedge funds are uncorrelated to equity markets.  Why they thought this would be true ad infinitum is beyond me.  Markets are non-linear dynamical systems.  They will never be the exact same in two different instances.  Therefore, all assets are destined to operate differently in different instances.

This is the point in the argument where Nassim Taleb would say – “aha!  black swans can’t be avoided”.  But to assume that the black swan is unavoidable is incorrect in my opinion for there are always and will always be uncorrelated asset classes in any investment environment.  Good risk managers know how to consistently maintain these high levels of non-correlation in all markets (I should add – good risk managers are a rare breed).  Of course, the true holy grail is pinpointing those uncorrelated assets at the correct time, but that doesn’t mean they aren’t there.

As a risk manager I utilize two uncorrelated tools that are too often overlooked –  cash and currencies.  See, the investment world doesn’t like high cash levels because that means they don’t make any fees.  In fact, they are paying YOU to hold cash.  It is no different than the blackjack player who sits out most hands.  Casinos hate that.  Why?  Because there is no money in a player that doesn’t play. Your broker thinks no differently of you.  Hence, the reason why 95% of all investment banks and advisors maintained at least a high level of buy and hold ratings all last year.  They want to keep you in the game.  See the chart below and notice the consistent 5% sell ratings by analysts.  Do you mean to tell me that during one of the greatest collapses in economic history the level of stocks rated “sell” never moved above 5%?  That is an utter embarrassment for the entire Wall Street community.  In my own business I rarely have more than 5% of the entire stock market on my BUY list.


The beauty of cash and currencies is that it always has a low level correlation to all assets.   And in the zero-sum currency world, by definition there is ALWAYS something uncorrelated.  I did not outperform the market by 60% last year because I am a genius.  I did so because I moved into cash and uncorrelated currencies when the risks appeared skewed to the downside.  In essence, I mucked my cards after an incredible series of face cards ran the deck and the odds changed.

In summary, there are always uncorrelated assets, but they are unlikely to maintain the same correlation throughout all market cycles due to the fact that all market cycles are different.   Finding them is of course the key, but assuming they aren’t there is just as silly as assuming that the Wall Street banks are looking out for you by keeping you in the game all the time.

(Related topics – Money Management)


Got a comment or question about this post? Feel free to use the Ask Cullen section, leave a comment in the forum or send me a message on Twitter.

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • jt26

    Hi TPC, good stuff.
    I’m a newbie on forex. (Use currency ETFs, EMB, global MMFs etc. only.)

    Do you or other TPC readers have any pointers or links on “advanced” forex for retail investors:
    (a) what can we really practically trade (spot, 5 year forwards, options, futures, global NDFs, swaps?)?
    (b) practical issues (brokers, important market pricing/indices … even if I don’t trade swaps I’d like to monitor the market indices because they influence my overall macro view … e.g. like ABX, CDX etc.)
    Thanks all.

  • JACK

    I remember when the strong dollar was bullish for stocks and other asset classes. Someday the rules will change entirely again and it will catch 95% of people by surprise.

    Thank you, TPC. Excellent content here. You are putting out some of the best stuff on the web. When I see 90% of investors getting their financial news from Jim Cramer and Fox News, I smile to myself and hope the secret doesn’t get out.

  • JeffT

    Thanks again. It is commentary like this that brings me here everyday.

  • JACK

    TPC, thanks for reminding us on the value of holding cash. With headlines in the financial media talking about how the worse is behind us, complacency has come back and I really think people are underestimating black swan tail risk.

    The Adminstration and FED are playing a dangerous game of chicken with the currency and commodity markets. They are throwing the kitchen sink in terms of stimulus at the economy, despite evidence that it’s not working and without regard to how its trashing the dollar. The only reason that this continues is because the bond market is firmly in the deflationist camp. At some point, spiraling deficits will reverse the bond market’s thinking and cause yields to rise. at some point, we are going to have another black swan event because of a convergence of higher interest rates, a collapsed dollar, higher oil prices, and the next wave of defaults. Underlying all this will be ill-timed health care initiatives that pile on more debt and intractable unemployment that hasn’t budged because our economy has no non-boom industries that can drive organic, non-public sector employment.

  • Rob


    If you believe that March 9 marked a fundamental low which will not be broken, why not just stick with buy and hold from then on out rather than trying to time the market’s future ups and downs?

    I almost completely exited the market in October 2007 (lucky bet, but based in my intense fear of loss which is stronger than my fear of lost opportunity) and bought in March 2009 (but only 75% of normal allocation to equities). I then sold most with the market near 900 and froze when the market jumped higher in July. I then bought back in at about 990 (50%) on the same Friday you announced that you sold. (I bought because of dollar issue. I have been afraid my dollars are going to hell and a Euro bank account which earns zero interest and foreign stocks are my only currency hedge.) I have been waiting for a significant correction which will never come. I would be much happier today if I had just bought in February/March to hold forever – even if the market makes new lows eventually.

    I missed about 20% points of the rally overall. I am now hoping the market goes back down to let me recoup the missed opportunity. I am afraid to invest more at this level, but afraid also that the market will suddenly jump much higher. If I were simply fully invested from March on I would be happy to sit back and watch the market go up or down. Being a “spectator”. This time fully invested.

    Psychologically I can handle losing paper gains (investing low – watching the market go up and back down), but not investing money sitting in cash and taking signficant paper losses (watching the market go down even if I am convinced it will go back up).

    My seach for what to do next lead me to start reading your site (which is great) and has led me to some great sources of wisdom which I never knew existed (e.g. GMO’s Grantham)

  • TPC

    I can’t think of any off the top of my head, but there are hundreds out there on google. I learned it more by just trading it.

  • TPC

    The other thing it – everyone says cash is so expensive right now compared to other assets. Really though? How expensive is cash in a zero interest rate zero inflation environment?

  • TPC


    Thanks as always for your great commentary. My personal problem with buy & hold is that I don’t think the market forecasts out more than a quarter or two ahead. No one really know what is going to happening a year or more out. There are lots of guesses, but no one really knows.

    In an environment such as this there is the potential for a Japanese outcome. This is a highly unusual economic event. It is a game changer. With my money, I would prefer to play the short term trades (which has served me very well over the last few years) as opposed to holding and hoping.

    The odds in this environment favor an investment duration that is consistent with a high risk environment. Otherwise, you’re just a feather in the wind hoping the winds take you to your goals….

  • TPC

    Lots of typos there. Sorry.

  • Rob

    I am afraid of the Japanese outcome as well. I was hoping for a market outcome more like that Great Depression… a 2 to 3 year decline to a low way below fair value (say S&P 500 at 400) followed by a bumpy recovery, deflation, reasonably high real interest rates and dividend yields north of 4%.

    How selfish of me. I think my wish has hurt my karma and jinxed my investing.

    Ninety percent of the population (except maybe retirees) is hoping for high inflation to wipe out their debts and is praying that Bernanke can reflate the equity markets and home prices go back highs since they have practically no real savings.

  • Octopus

    Thank you TPC, very nice article, I share all his views. I’m trading mkts for more than 16 years and I went trough many changes in correlations. I think the most difficult thing is to understand -on time-that the market is changing, especially when you are on a winning streak. I’m based in Europe and I usually trade European stock index futures, major FX forwards, IR futures and cash German govt bills and notes that I keep as collateral. I try to spot attractive technical set ups and trade it accordingly with large stops, the average time frame of my positions is usually a few weeks. 2008 was a very good year since I managed to profit from a good part of the downmove on eqty mkts, and the move on Yen crosses. This year is much less brilliant since I missed the whole eqty upmove -and lost some money trying to short it- but I got it right on Bund futures and I’m even on FX.

  • Onlooker


    The Japan scenario or the ’30-’32 scenario is where I think we’re headed, depending upon the Fed’s actions. Either way is terribly destructive to your wealth if invested buy and hold, needless to say.

    And I’m not convinced that the March lows will hold. It’s just too dangerous to buy and hold without a secular updraft behind you. And we’re a long way from that.

    That said, I do think we have to be on guard against the possibility of high inflation. But I don’t think we’re there yet. The herd (including some respected namesm, no doubt) is ahead of that trade, IMO. And holding inflationary hedges through another bout of large deflationary pressure will be nasty, as it was last year.

    Tough times, indeed.

  • Van


    I would like to add my thanks for an excellent article, as a technical analyst using trend reversal indicators (similar to DecisionPoint) my interest is the asset’s trend regardless of historical tendencies. My original challenge was in minimizing the number of false alarms generated by my indicators. Now that my indicators have improved significantly, my challenge is the allocation of investment funds at any given point between signals as they apply to various asset classes.