A Trader Journal

Traditionally when people think of diversification, we approach from asset class diversification perspective. A big problem with this approach is the portfolio risk protection (i.e., diversification) disappears exactly when it is needed most like during regime shifts that happened in 2000 or 2008. The reason being whenever major market drops happen, most assets become highly correlated making diversification not effective. Actually I think substantial increase in correlation of typically diverse asset classes is good indicator that a regime shift is underway.

So how do one address this issue? Following is a good paper that approaches diversification from risk factor perspective. On average, correlations across risk factors are lower than correlations across asset classes, and risk factor correlations tend to be more robust to regime shifts.

Diversification - the only free lunch in finance!