When I was at university, I learnt one of the great principles of modern finance: A diversified portfolio reduces risk for a given level of return. By mixing assets, you could smooth the ride and still aim for the same target return. It felt like magic.
But it is not magic. The reason it is such a powerful and enduring concept is correlation. If assets do not move together, the losses in one can be offset by gains in another. It is the foundation stone of portfolio theory, and for good reason. Even the great Ray Dalio — founder of Bridgewater hedge fund — claims that his “mantra of investing” is “15 good uncorrelated return streams ... [that] lower [his] risk by up to 80 percent”.
So far, so neat. But there is a catch.
The mid-2000s provide a reminder of how wrong people can get things. Banks packaged subprime mortgages into securities; rating agencies stamped their AAA rating “seal of approval”; and investors, trusting that these people knew wha
