Shaken to the core...

As we approach the end of what is shaping out to be one of the most disastrous years in financial market history, challenging even the most fundamental concepts of modern portfolio theory, we are left to ponder if the industry will have to reinvent itself.
Fundamental concepts and measures such as Value at Risk (VAR), standard deviation, the normal distribution, correlation or even diversification are being questioned in light of the way this crisis has unfolded.
For example the foundation of modern portfolio theory lies on the premise that diversification in a portfolio contributes to enhancing returns and reducing risk. Well if we apply it over the past year and a half we can firmly conclude that it has failed miserably. In fact we could argue in the case of equity markets that in certain situations, diversification has actually magnified losses. A U.S. or European investor, for example, was much worse off with exposure to emerging markets.
Related to this is the concept of correlation whereby a weaker correlation between two investments contributes to enhancing the risk/return tradeoff of a portfolio. But all this becomes hogwash or even worse when those same correlations suddenly jump up to a level close to 1.
So where does this leave us? Do we just abandon the very core foundations of modern portfolio theory and search elsewhere for answers or do we just stick to them and ride this crisis out?
History, in this case, does provide clues since it is not the first time that the core concepts have been challenged like this. The main lesson we can draw from the past is that these concepts only function in normal market environments. In other words they are prone to failure when markets are either in a bubble or when they are experiencing a crash, and since a crash is arguably (arguably because they too can be exploited) the least desirable environment to be in and thankfully don’t last too long, it makes no sense to abandon these core concepts if things will eventually return to normal.
Warren Buffet recently stated that the biggest losers in this crisis are going to be those that are currently sitting on cash. That is because by the time you know that things are improving, it will be too late to do anything about it. This particular market correction has two parts to it, one related to a reversion to the mean effect (reflecting the fundamentals) and another that is emotionally driven and that tends to exaggerate things both on the downside and the upside. The first part will take time to fix as the world is entering what could become a protracted recession. The second part, however, will resolve itself as soon as all the bad news is out in the open. When that happens, however, it will be too late to do anything about it.