Diversification Failure

Diversification failure happens when assets that were expected to be uncorrelated begin to move together, usually during a period of intense market stress. This phenomenon is common in the cryptocurrency market, where liquidity crunches can force investors to sell everything simultaneously to meet margin calls.

When diversification fails, the protection offered by holding a variety of assets vanishes, and the portfolio's risk increases dramatically. This is often referred to as correlation convergence, where the correlation of all assets approaches one.

Understanding the conditions that lead to diversification failure is vital for risk management. Traders must account for this by incorporating stress tests that simulate extreme correlation scenarios.

It highlights the limitation of relying solely on historical correlations for future risk assessment. Recognizing this failure is key to surviving major market drawdowns.