204 The fast roa d dow n
revealed in 2008. Finally, the whole world depends on the US markets as
equally painfully proved during the 2008 meltdown. It is difficult enough
to accurately assess past correlations, so it’s hardly surprising that we run
into trouble when what we are looking for is not a measure of the past but
an estimate of future correlation. Then we must try to gauge how we can
get the most diversification from investing in a combination of markets.
Past correlation data may provide a good guide for estimating future cor-
relation, but counting on those numbers alone to make precise forecasts
would be unwise; the world and correlations change constantly.
Creating a diversified portfolio
What we are trying to do is to create a portfolio of well-diversified liquid
markets across the world in a way that is cheap to put together and where
we have a reasonable estimate of the risk we are undertaking. While invest-
ing assets such as real estate or private equity may be appealing, they are
less liquid and often come with high fees. Instead we should focus on
liquid debt (corporate and government) and equity markets across the
world where we have an expectation of positive returns (as we do in most
markets), an idea of how the tradeable values move relative to other mar-
kets (correlation), and a reasonable estimate of the risk of each individual
investment (volatility). In finance theory, what we are trying to do is to
create a real-life practical investment on the ‘efficient market frontier’. For
the very technical, there are two areas where we differ from traditional
finance theory: we will not be investing according to market sizes (that
would lead to disproportionate investments where capital markets make
up a large percentage of GDP (gross domestic product) and leave us with
mainly the USA and Western Europe), and we do not think the expected
returns across the world strictly follow the methodology of the Capital
Asset Pricing Model (CAPM). This would suggest that the risk premium in
smaller markets is barely above zero.
The main concern with a broadly diversified portfolio is that diversifica-
tion gives a false sense of security. When the shit hits the fan, all markets
act as one and our fancy charts go out the window, along with correlation
assumptions, especially in emerging markets. During the 2008 meltdown,
no markets were spared, just as in September 2001 when they all took a hit

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