Modern Portfolio Theory remains a major part of many investment portfolio allocation processes. Basically, the idea of MPT is that one can combine a collection of securities into a portfolio which offers comparable return prospects with reduced risk. This is done by mixing together stocks and other assets which are not well correlated, or perhaps are negatively correlated.
Sounds good, right?
The problem is, as has been discussed, that individual stocks have become extremely highly correlated to the market in recent years. This, by definition, means they have become increasingly correlated to each other as well, reducing the opportunity for diversification in portfolios using the old methods.
Another issue with MPT-based portfolio development is the fact that correlations change over time and in different time frames. The chart below from Oanda shows a recent set of correlations between EUR/USD and other currency pairs (as well as gold and silver).
Notice in the AUD/USD column how the correlations to EUR/USD are strongly positive (darkest red) in the hour, day, and week time frames, but then are uncorrelated in the longer time frames, and even negatively correlated at 3 months. In the case of USD/JPY we can see the correlations are very time frame depended, running the full spectrum over the time frames. Even with silver and gold (XAG/USD and XAU/USD) the correlations aren’t consistently strongly positive.
All this correlation variation creates considerable challenges to standard asset allocation and portfolio development methods and approaches. Imagine creating a portfolio of stocks that have been properly minimally correlated only to have them all become highly correlated? It would totally change the portfolio’s risk dynamics, and likely at the worst possible time.
This is where the importance of considering diversification not just in terms of markets and securities, but also in terms of trading/investing approach becomes clear. This is the approach of fund-of-fund investors. They seek out uncorrelated money managers, exactly the same sort of thing you can do by taking part in the Trade Leaders program.
Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.