When Diversification Fails

One of the most vexing problems in investment management is that diversification seems to disappear when investors need it the most. We surmise that many investors still do not fully appreciate the impact of extreme correlations on portfolio efficiency—in particular, on exposure to loss. We take an in-depth look at what drives the stock-to-credit, stock-to–hedge fund, stock-to–private asset, stock-to–risk factors, and stock-to-bond correlations during tail events. We introduce a data-augmentation technique to improve the robustness of tail correlation estimates. Finally, we discuss implications for multi-asset investing.