INVESTING - The Myth of Noncorrelation

The ugly spillover of the U.S. subprime mess into bond and equity markets around the world should come as no surprise to investors. History has proven again and again that seemingly unrelated markets tend to move in lockstep during times of crisis. What catches many investors off guard is not the behavior of individual markets but the concurrent big and unexpected moves among markets. It's the surprising linkages that suddenly appear between markets that should not have much to do with one other and the failed linkages between those that should march in tandem. That is, investors are not as dumbfounded when volatility skyrockets as when correlations go awry. This may be because investors depend on correlations to control their risk and to allow them to extend further out in their investment exposures. Correlation is the key for hedging and diversifying. Correlations between markets can shift wildly and in unanticipated ways, and usually at the worst possible time, when there is a crisis with volatility that is out of hand.