Title: CORRELATION, VARIANCE, SEMI-VARIANCE AND COVARIANCE ARE IRRELVANT IN RISK ANALYSIS, MECHANICS AND PORTFOLIO MANAGEMENT.

AUTHOR: MICHAEL NWOGUGU, Certified Public Accountant (Maryland, USA). Address: P. O. Box 996, Newark, NJ 07101, USA. Phone: 1-917-652-9289; Email: mcn2225@aol.com; mcn2225@gmail.com. Keywords: Correlation; Covariance; Variance, Semi-Variance, Volatility; Risk Analysis; mechanics; Portfolio Management. Abstract Modern risk analysis, portfolio management and mechanics are based almost entirely on the meanvariance framework and its elements variance, semi-variance, correlation and Covariance. Unfortunately, these measures are very inaccurate and dont reflect the realities of phenomena, and are also theoretically inappropriate. This article illustrates the many problems and constraints inherent in the mean-variance framework and its elements.

Existing Literature The existing literature on the validity of correlation, covariance, semi-variance and variance is somewhat scant. These three measures are used extensively and almost exclusively in many fields including physics, epidemiology, finance, etc.. Relevant articles include: Roll (1977); Joyce & Vogel (1970); Weber & Shafir (2004); Gro& Wu (2006); Petz (2002); Sutton (2003); Wyart & Bouchaud (2003); Nunes, Buldyrev, Havlin, Maass, Salinger et al (1997); Henderson & Williams (1979); Gatti, Di Guilmi, Gaffeo et al (2005); OBrien (1981); Webster & Cho (2006); Kullmann, Toyli, Kertesz, Kanto & Kaski (1999); Doplicher, Kastler & Robinson (1966); Rice (January 2004); Bunke & Wandl (1980); Lingyun (2007); Mukhopadhyay (_______); Li (2005); Lima (2005); Lima (2005); Solomon (1985); Davis et al (2000); Kauemann & Carroll (2001); Levy (1980); Sullivan & DAgostino (2002); Sullivan & DAgostino (______); Neng-Hui & Wheyming (1996); Brown & Kros (2003); Goldsman & Kang (1985); Goldsman (1984); Kang (1984); Fishman (1978); Goldsman & Schruben (1989); Timm (1970); Waggle & Moon (1970); Holtgrave & Weber (1993); Weber (2006); Weber & Siebenmorgen & Weber (2005); Klos, Weber & Weber (2005); Loewenstein, Weber, Hsee & Weich (2001); Bontempo, Bottom & Weber (1997); Palmer (1996); Slovic & Weber (April 2002); Slovic, Fischhoff & Lichtenstein (1984); Weber & Hsee (1998); Weber & Milliman (1997); Zhou, Cai, Teo & Yang (2000); Zhou &

Dokuchaev (2001); Zhou & Lim (2001); Zhou & Lim (2002); Zhou, Cai, Teo & Yang (2004); Zhou, Choulli & Taksar (2004); Zhou, Jin & Yan (2005); Zhou, Bielecki, Jin & Pliska (2005); Zhou, Jin & Markowitz (2006); Golec & Maurry (1995); Harris & Raviv (1993); Dunning, Griffin, et al. (1990); Levy, Guttman & Tkatch (2001); Levy & Schwartz (1997); Zeiring, Liang & McIntosh (1999); Kang & Goldsman (_______); Lindman, Sner, Ziegler & Jackson (1976); Dawei (1994); Chadoeuf & Denis (1991); Burman & Shumway (1998); Lowe & Muller (2004); Burton, Scurrah, Tobin & Palmer (2005); OHara, Hines & Hines (2007); Landis, Miller, Davis & Koch (2006); Estrada (2003); Danielsson (2002); Alanagar & Bhar (2003); Caporale, Spittis & Spagnalo (2002); Gopikrishnan & Plerou, et al. (2000); Pafka & Kondor (2001); Tucker (1997); Nwogugu (2006); Tseng & Wang (2008); Neely (2008); Allen & Morzuch (2006); Nelson & Wu (1998); Nelson (1992); Nelson & Foster (1995); Adrian & Rosenberg (2006); Prono (2006); Bollerslev & Zhou (2001); Halunga & Orme (Jan. 2005); Carnero (2004); Molinas (1986); Sollis (2005); Braha & Bar-Yam (2007); Shugan & Mitra (2009); Broersen (1998).

Other relevant articles pertaining to risk in finance and business include: Philippatos G (1979). Ahn &

Gadarowski (1996); Kroll, Levy & Markowitz (1984); Adler & Kritzman (2007); Liu (2004); Liu (2004);
Adler & Kritzman (2007); Chew & Epstein (1989); Loomes & Sugden (1982); Geiger (2002); Martellini & Urosevic (2006); Briec, Kerstens & Jokung (2007); Lee (1997); Bond & Satchell (2002); Estrada (2004); Weber (2006); Ku (2006); Sira (2006); Ashar & Wallace (1963); Thomson & Hazell (1972); Fishburn (1984); Porter (1974); Chen, Lee & Shrestha (2001); Veld & Veld-Merkoulova (2007); Ebnother & Vanini (2007);

Goovaerts, Kaas, Dhaene & Tang (2004); Landsman & Sherris (2001); Danielsson, Jorgensen & Sarma & Vries (2006); Szego (2005); Green & Hollifield (1992); Moskowitz (2003); Goyal & Santa-Clara
(2003); Hwang & Satchell (2005); Solnik & Roulet (2000); Yu & Sharaiha (2007). The existing gaps in the literature include: 1. Analysis of accuracy of Covariance, variance, Semi-Variance and Correlation with respect to time. 2. Analysis of conditions under which Correlation/Covariance/Variance/Semi-variance will not be accurate. 3. Analysis of effect of excess dispersion of data, on accuracy of Correlation/Covariance/Variance/Semi-

variance. 4. Analysis of effects of sample selection methods on accuracy of Correlation/Covariance/Variance/Semivariance. 5. Analysis of effect of cost of capital, and availability of capital on Correlation/Covariance/Variance/SemiVariance in financial markets. 5. Analysis of the impact of the Substitution Effect on accuracy of Correlation/Covariance/Variance/Semivariance.

I. Feasibility Conditions For Correlation, Covariance, Semi-Variance And Variance. Correlation, Covariance, Semi-Variance and Variance (C/C/SV/V) supposedly measures the magnitude of the variation or co-variation of variables with regard to the units of measure; while correlation measures co-variation without regard to units of measure. The general formulas for Correlation, Covariance and Variance are as follows:

Covariance = Ccov = [{(1-x)*(1-y)}+{(2-x)*(2-y)}.+..+(n- x)*(n- y)]/. Correlation = Ccor = Ccov/(y*x) Variance = V = x2 = [(1-x)2+ (2-x)2.+..+(n- x) 2]/. Semi-variance = SV = [Min{(1-x),0}2+ Min{(2-x),0}2.+..+Min{(n- x),0}2]/.

Where: x = mean of variable for periods. y = mean of variable , for periods. i = value of variable in period i. i = value of variable in period i. Ccor = correlation. N = number of periods. N, where is the number of time intervals. i . Ccov = covariance. x = standard deviation of x in period . y = standard deviation of y in period . V = variance SV = Semivariance Ux+/Ux- = utility/disutility gained from increase/decrease in variable x. U = utility/disutility from covariance/co-movement of two series.

 = Skewness = Kurtosis t = tax r = interest rate Theorem 1.1: The Correlation Formula Is Incorrect Under All Circumstances. Proof: The current Correlation formulas can be valid iff all the following conditions exist simultaneously: 1. x/i 0 2. x/i > (-1) 3. x/i = y/i 4. 2U/(i-x)(i-yn) 0; 5. x/x = y/y; and 2x/x2 = 2y/y2 6. x/(i-(i-1)) = y/(i-(i-1)) 7. x/(i-x) = y/(i-y); and 2(i-x)/x2 = 2(i-y)/y2 ; 8. (i-x)/(i-yn) 0; 2(i-x)/(i-y)2 0; 9. 2x/ix = 2y/iy 10. x/ = yn/; and 2x/2 = 2yn/2 11. i/ = 0; and i/ = 0; 12. 2Ccov/r = 0 (finance only) 13. x/ = 0; and 2x/2= 0; and x/ = 0; and 2y/2 = 0 14. x/i = y/i 15. x/i = y/i = 0; and 2x/i2 = 2y/i2 = 0 16. 2Ccov/xy = 0; 17. y/i = 0; and x/i = 0 18. V/x = 1; 2V/y2 > 0 19. (i-x)/ = 0; and (i-y)/ = 0; 20. 2U/xx = 0 (finance only) 21. 2U/ > 0; 22. i/(i-1)) = 0; and i/(i-1)) = 0; 23. U/V = 0 (finance only) 24. 2U/t = 0 (finance only) 25. 2Ccov/r = 0 (finance only) 26. 3U/x = 0 (finance only) 27. 2U/ir > 0 (finance only) 28. (i-x)/r = 0 (finance only) 29. [(i-x)2]/i = 1; 2[(i-x)2]/i2 > 0; 30. (i-x)/ = 0; 31. U/(i-x) > 0; and 2U/(i-x)2 > 0; (finance only) Since none of these conditions are feasible, Correlation is inaccurate. Theorem 1.2: The Variance Formula Is Incorrect Under All Circumstances. Proof: The current Variance and Semi-Variance formulas can be valid iff all the following conditions exist: 1. 3K/1x = 0 2. V/ = 0; 2V/x = 0; 3. V/x = 0; 4. [(1-x)2]/ = 0 ???

5. x/ = 0; 6. x/[(1-x)2] = 1 7. [(1-x)2]/x > 0; this implies that Variance/Covariance/Correlation are not valid for any series or pair of series in which most of the numbers are less than one, and or the means are between zero and one. 8. 2Ccov/xy = 0 9. [(1-x)]/[(i-y)] = 0 10. x/y = 0 11. [(1/i)*(x/y)] >0; and [(21/i2)*( 2x/y2)] >0; 12. 1/i x/y 13. 2V/x = 1 14. (i-x)/ = 0; 15. x/[(1-x)] 1 16. x/ = 0; and 2x/2 = 0; 17. [(1-x)]/x = 0; ????? 18. 1/x = 0; and 21/x2 = 0; 19. /x = 0; and 2/x2 = 0 20. 3/1x = 0 21. 2/(1-x) > 1; 22. / 1; and 2/2 >0 23. /1 > 0; and 2/12 > 0; 24. 2/ 1 = 0 25. V/x = 1; 2V/x2 > 0 26. (i-x)/ = 0; 27. 2U/xx = 0 (finance only) 28. 2U/ > 0; 29. i/(i-1) = 0; and i/(i-1) = 0; 30. U/V = 0 (finance only) 31. 2U/t = 0 (finance only) 32. 2Ccov/r = 0 (finance only) 33. 3U/x = 0 (finance only) 34. 2U/ir > 0 (finance only) 35. (i-x)/r = 0 (finance only) qq36. [(i-x)2]/i = 1; 2[(i-x)2]/i2 > 0; 37. U/(i-x) > 0; and 2U/(i-x)2 > 0; (finance only) 38. SV/x = 1; 2V/x2 > 0 39. U/SV = 0 (finance only) 40. SV/ = 0; 2SV/x = 0; 41. SV/x = 0; 42. 2SV/x = 1 Since none of these conditions are feasible, Variance and Semi-Variance are inaccurate. Theorem 1.3: The Covariance Formula Is Incorrect Under All Circumstances. Proof: The current Covariance formulas can be valid iff all the following conditions exist simultenuously: 1. 3/1x = 0 2. V/ = 0; 2V/x = 0; 3x/Vx = 0 3. V/x = 0; V/y = 0 4. [(1-x)2]/ = 0 5. x/ = 0; 6. x/[(1-x)2] = 1;

7. [(1-x)2]/x > 0; this implies that Variance/Covariance/Correlation are not valid for any series or pair of series, in which most of the numbers are less than one. 8. 2Ccov/xy = 0; 9. [(1-x)]/[(i-y)] = 0; 10. x/y = 0; 11. (1/i)*(x/y) > 0; 12. 1/i x/y 13. 2V/x = 1; 14. (i-x)/ = 0; 15. x/[(1-x)] 1; 16. x/ = 0; and 2x/2 = 0; 17. [(1-x)]/x = 0; and 2[(1-x) 2]/x2 18. 1/x = 0; and 21/x2 = 0; 19. /x = 0; and 2/x2 = 0; 20. 3/1x = 0; 21. 2/(1-x) > 1; 22. / 1; and 2/2 > 0; 23. /1 > 0; and 2/12 > 0; 24. 2/1 = 0; 25. V/x = 1; 2V/y2 > 0; 26. (i-x)/ = 0; and (i-y)/ = 0; 27. x/i >0; y/i = 0; 28. 1/y = 0; i/x = 0; this implies that any significant positive or negative co-movement between the mean of one series and the other series renders covariance/variance/semi-variance useless. 29. 2U/xx = 0 (finance only) 30. 2U/ > 0; 31. i/(i-1)) = 0; and i/(i-1)) = 0; 32. U/V = 0 (finance only) 33. 2U/t = 0 (finance only) 34. 2Ccov/r = 0 (finance only) 35. 3U/x = 0 (finance only) 36. 2U/ir > 0 (finance only) 37. (i-x)/r = 0 (finance only) 38. [(i-x)2]/i = 1; 2[(i-x)2]/i2 > 0; 39. U/(i-x) > 0; and 2U/(i-x)2 > 0; (finance only) Since none of these conditions are feasible, Covariance is inaccurate.

II. Other Issues The deviations from the means of the series (which are the foundation for C/C/SV/V) are not calculated with respect to their time of occurrence. Hence, C/C/SV/V errorneously assume that all time intervals are equally relevant, and that any co-movement does not depend on time. On the contrary, there are many situations and time series, where certain time intervals have little or no activity or readings and other intervals traditionally have substantial activity and or a large outlier and this reduces the accuracy of C/C/V/SV.

Thus, C/C/V/SV dont capture the co-movement that is attributable to cycles, and the co-movement that is attributable to the passage of time. Furthermore, the deviations from the means attempt to measure only horizontal co-movement, but not longitudnal co-movement. In many circumstances, longitudnal comovement is more relevant than latitudnal co-movement. The remainder of this document analyzes other issues pertaining to the accuracy of Correlation/Covariance/Variance/Semi-Variance. Hypothesis-1: Correlation/Variance/Covariance/Semi-Variance Are Errornously Based On Standardized Numbers And The Normal Distribution; Standardization Of Time Series Greatly Reduces The Informativeness of The Series. Proof: Correlation/Covariance/Semi-Variance/Variance (henceforth, C/C/SV/V) dont appropriately consider the magnitude of the standard deviations of the two series standardization of data results in loss of information content, because: a) standardization imposes a specific distribution that typically does not match reality, b) standard deviation is extremely sensitive to outliers, c) standard deviation is not calculated with respect to time, and does not consider cyclicality. Standardization does not fully incorporate the magnitude of variations around the mean. In Correlation/Covariance/Variance formulas, the magnitude of the deviations from Means errorneously affects the likelihood that the two series will be deemed as positively or negatively related. Correlation/Covariance/Variance and the variables used in calculating them, are based on Standardized numbers from the Normal Distribution. The Normal Distribution has been shown to be improper for many types of series, particularly financial series. Ideally, a measure of co-movement should not be based on any assumed statistical distribution. Standardization supposedly improves comparability of any two series (for purposes of calculating Variance/Covariance/Correlation) and eliminates the effect of type/magnitude of units of the series. However, standardization reduces the usefulness and information content of the series.

Hypothesis-2: Correlation/Covariance/Variance/Semi-Variance Erronously Assume That The Mean & Standard Deviation Are Constant.

Proof: C/C/SV/V erroneously assume that the mean of the two series are constant over the analysis period n. In every time series, the effective Mean changes in each period/interval, and in many instances, the actual Mean changes instantenously; and these changes are not captured by C/C/V/SV. Similarly, C/C/SV/V are based on a constant standard deviation over n periods, whereas in reality, the standard deviation changes over time.

Hypothesis-3: Correlation/Covariance/Variance/Semi-Variance Overstate The Impact Of Outliers; And Dont Fully Incorporate Effects Of Major Deviations From Means. Proof: C/C/SV/V grossly overstate, and are extremely sensitive to the effect of outliers. In the existing formulas for C/C/SV/V, one single large outlier can completely distort the actual and perceived variation or comovement of series. Hence, the predictive usefulness of C/C/SV/V declines as the standard deviation of either series increases, because: a) the Mean become less relevant as a representation of the series, b) the range of possible values increases. Correlation/Covariance dont fully capture or incorporate the effect of significant deviations from the means of series. In essence, the correlation/covariance between two series which both have significant deviations from their means, can be different from the correlation between two other series which have low deviations from their means, where both have the same magnitude of actual co-movement - in C/C/SV/V formulas, the magnitude of correlation/covariance/variance is erroneously assumed to vary directly with the magnitude of the deviations from the Means of each series.

Hypothesis-4: When Calculating Correlation/Covariance, Multiplying Deviations From The Mean Produces Incorrect Results. Proof: The calculated magnitude of Correlation/Covariance is supposedly based entirely on the deviations from the mean. But a closer look at the Covariance/Correlation formulas reveals that multiplying the deviations from the mean of each series in each time interval (rather than scaling or adding the deviations), has the effect of grossly overstating the co-movement of both series. This effect will be more pronounced in series with very large numbers than in series with small numbers, because there is no proportionality between i) the

co-movement and ii) the product of the multiplication of the deviations from the means of the two series.

Hypothesis-5: Correlation/Covariance/Variance/Semi-Variance Do Not Incorporate The Frequency Of Occurrence In Any Time Interval; And Dont Incorporate Volume Effects. Proof: In many circumstances in finance and dynamical systems, the frequency of occurrence (in finance, frequency of occurrence of elements of two series) is a significant indication of co-movement. Unfortunately, C/C/SV/V are erroneously based entirely on the matched-pair selection method which assumes that in each time interval, the variables in both series occur only once. On the contrary, and in many instances, variables in one or both series occur more than once in any given time interval, and the actual ratio of such occurrences in one time interval is a relevant indicator of co-movement. C/C/SV/V incorporate only the comovement of the magnitude of variables in the two series, which is grossly insufficient and erronously assume that any changes in magnitude of the variables occur only once and remain constant during the time interval. In financial markets and other situations, C/C/SV/V dont account for volume effects, and are based solely on matched pairs. The Volume of transactions (associative and related events) is a highly relevant indicator of co-movement of any two series.

Hypothesis-6: Correlation/Covariance/Variance/Semi-Variance Are Highly Sensitive To The Nature Of The Series, And To The Time Interval. Proof: Series can be calculated as: a) raw data, b) lagged raw data, c) first differences of the raw data, d) natural log of the raw data, e) percentage changes of the raw data, f) natural log of the percentage change of the raw data. Each of these alternatives will produce very different Correlation/Variance/Covariance coefficients this is a major weakness, because ideally, the form of the series should not affect the measure of co-movement (In portfolio management, the returns series and the underlying prices series often have different statistical properties). Series can be used in correlation calculations as hourly, daily, weekly, quarterly or annual data. The resulting C/C/SV/V coefficients will differ substantially for each time interval used. This is a major weakness

ideally, any accurate measure of co-movement should not be affected by the choice of time interval used for selecting variables.

Hypothesis-8: Covariance/Variance/Semi-Variance/Correlation Dont Account For Directional CoMovement. Proof: In many real world circumstances, the magnitude of co-movement of any two series varies with the trend of the two underlying series (upward trend versus downward trend versus flat movement). Hence there are two components of co-movement a) the magnitude of absolute co-movement, and b) the trend of movement of each series (ie upwards, downwards or flat). C/C/SV/V cannot indicate whether co-movement is greater when the trend of movement is one of three states defined as upwards, downwards or flat. Instead C/C/SV/V produces a single measure that averages all-co-movement regardless of the trend of the underlying series.

Hypothesis-9: The Mean Is Inefficient/Inaccurate. Proof: For any given series, the mean is not a good indicator of the nature of the series, because: a) the mean does not capture the effect of outliers, b) the mean is highly sensitive to the time interval (hourly versus weekly versus monthly, etc.), c) the mean does not incorporate the frequency of occurrence (assumes that there is only one occurrence per time interval), d) the mean does not capture utility of the series, e) the mean does not indicate major changes in the series (peaks and troughs) in an accurate and timely manner in many instances, the mean reflects these changes very gradually and only several intervals after occurrence, f) the mean is highly sensitive to very small and very large data in the series, g) the mean assumes that the population/sample is constant on the contrary, in many situations, the population/sample changes rapidly either by addition of new samples or by elimination of samples or by self-division, h) the mean can be calculated in various was (using different time intervals; using weighted means; etc.), each of which will produce a different result.

Hypothesis-10: The Predictive Usefulness Of Covariance/Variance/Semi-Variance/Correlation Is Highly Limited. Proof: C/C/SV/V do not account for perhaps one of the most important elements of risk analysis and

portfolio management - the estimates of the future. Correlation/Variance/Covariance are based exclusively on past events and patterns which may not occur in the future. In highly dynamical systems and evolving systems, Correlation/Variance/Correlation are virtually useless.

Hypothesis-11: Covariance/Variance/Semi-Variance/Correlation Are Inaccurate Because They Dont Account For ,Price/Magnitude Risk. Proof: Within the context of Covariance/Variance/Semi-Variance/Correlation, Price/Magnitude Risk is defined here as the risk that the absolute magnitude of one series may change significantly and adversely, if the other series changes. C/C/SV/V do not fully account for price/magnitude risk, primarily because they are based only on completed pairs and matched pairs C/C/SV/V are based only on completed transactions and associations, but dont incorporate un-completed transactions that are highly relevant indicators of comovement, such as un-matched trading orders in capital markets. The Un-completed Transactions can have substantial information content and motivation/de-motivation effects in systems.

Hypothesis-12: Covariance/Variance/Semi-Variance/Correlation Dont Account For Market Risk. Proof: Market risk is defined here as the risk that the overall trend/direction of the market (distinct from the asset) may move adversely. Note here that the term used is adverse, and that in some circumstances, a downward trend in the market is not necessarily a negative, depending on the traders portfolio. For example, for a given market and two price series, compare two scenarios: a) the market and both price series are trending downwards and the correlation between the price series is 0.5, and b) the market and both price series are trending upwards and the correlation between both price series is 0.5. Both correlations are exactly the same, but there are significant differences in the underlying market risk (and hence, the probability of stronger/weaker co-variation) which is not captured by correlation. Its clear that evaluation and quantification of co-variation has to incorporate the market risk and each assets sensitivity to market risk.

Hypothesis-13: C/C/SV/V do not account for Framing Effects. Collorary: C/C/SV/V do not account for framing effects inherent in the: a) structuring of

securities/assets, b) method of calculating the mean, c) how the series is presented, - ie the raw series versus the first differences of the series versus the natural log of the series versus a lagged series; d) effect of changes in the time intervals eg. daily versus weekly versus monthly versus quarterly data, etc..

Hypothesis-16: Correlation/Covariance/Variance/Semi-Variance Are Anchoring Effects And Hence, Are Inaccurate. Proof: C/C/SV/V are prime examples of defects of Anchoring Effects: a) focusing on, and use of specific intervals in selecting the data, b) focusing on, and calculating the Mean of each series based on a specific time interval; c) weighting the Means. Anchoring is only useful where conditions are static and stable. In dynamic conditions, Anchoring results in significant distortions and negative Framing Effects.

Hypothesis-17: Selection Bias. Collorary: C/C/SV/V do not account for effects of Sample-Selection Biases such as: a) time interval; b) magnitude; c) treatment of outliers, d) matched-pairs and matching of samples, e) averaging of samples, f) selection of period of analysis, g) population size. These Sample Selection Biases distort the information content of underlying data.

Hypothesis-18: C/C/SV/V dont incorporate or account for Psychological Processes. Collorary: C/C/SV/V dont incorporate or account for the psychological processes inherent in: a) the series, b) the decision making processes that lead to, or result in the series, c) psychological effects that result from the series. C/C/SV/V are highly isolated measures that are not informative about the underlying transactions. Various published studies have shown that risk, perception of risk and perception of series, involves and results in distinct psychological effects and processes. Correlation/Covariance erroneously assumes that one hundred percent of deviations from the Mean of one series, is attributable solely to the other series. Variance/Semi-Variance erroneously assume that one hundred percent of the variation in the series is attributable solely to changes in the underlying variable during each sequential time interval ie. C/C/SV/V does not account for what is now termed serial auto-correlation.

Hypothesis-19: C/C/SV/V do not incorporate or account for Regret. Proof: In financial markets, Regret accounts for a substantial portion of activities in risk management and portfolio re-balancing. In non-financial dynamical systems, Regret can also be a major decision factor or control factor. In the context of risk, the elements of Regret are: a) the actual and perceived covariation/variation of series based on revisions of beliefs, and changes in knowledge; b) the effects of Regret on changes in the series and changes in co-movement of the series; c) changes in utility arising from Regret; d) the changes in the propensity to complete transactions which is wholly or partly attributable to Regret. It can be shown that in financial and non-financial dynamical systems, the magnitude/direction of variability of any one series, and the magnitude and direction of co-movement of any two series is directly related to Regret.

Hypothesis-20: Correlation/Variance/Correlation/Semi-Variance Dont Incorporate or Account For Utility/Disutility In Risk Analysis. Proof: In financial markets, utility is typically expressed in terms of Means and standard deviations. In financial markets, risk analysis and some areas of mechanics, the very essence of the analysis of co-movements of two series, is the utility/disutility gained from such co-movements, and from knowledge/expectation of such co-movements. The utility/disutility inherent in the co-movements has several components: a) the actual comovements, b) the differences in utility/disutility gained from analysis co-movements using data presented in different formats (raw data versus first differences versus percentage changes, etc.), c) the expectations of future co-movements. In essence, absolute C/C/SV/V without regard to utility (financial markets) or causal factors (risk analysis and mechanics) is meaningless: a) under the present C/C/SV/V formulas, a specific level of Correlation/Covariance/variance has different meanings to different persons depending on their risk aversion, knowledge, perception, ability to discern framing effects, etc., b) the mean-variance framework which frames risk in terms of variance and expected returns, does not incorporate the effects of short selling, loss-seeking, ability to transfer/defer risks and synthetic securities.

Hypothesis-22: C/C/SV/V dont account for changes In The Availability Of Capital, And Cost-Of-Capital Proof: In the context of financial markets, C/C/SV/V dont account for changes in availability of capital and cost-of-Capital; but rather, erroneously assume that capital is constant during the analysis period. In financial markets, changes in availability of capital and cost-of-capital affect trading volumes, asset prices and hence, the co-movements of asset prices. Similarly, in some aspects of mechanics, C/C/SV/V erroneously assume that there is constant energy in a system, and dont account for changes in availability of enerty and possible transformations of energy.

Hypothesis-23: Correlation/Covariance/Variance Dont Incorporate The Substitution Effect Proof: C/C/SV/V dont incorporate Substitution Effects. Substitution Effects refer to the ability to substitute and impact of substituting all of part of one series with another series. In financial markets (and some other fields), covariance/variance/ correlation are used primarily for purposes of assessing substitutability of assets (series) and associated utilities over time. Hence, absolute Variance/Covariance by itself, without reference to substitutability is almost meaningless. The true risk of: a) one series that cannot be wholly or partially substituted, and b) another series that can be wholly or partially substituted, cannot be completely explained by Variance/Covariance/SemiVariance formulas. Similarly, the true co-movement of: a) two series, each of which cannot be wholly or partially substituted, and b) the same two series, but where both can be wholly or partially substituted, differ significantly.

Hypothesis-24: Correlation/Covariance/Variance/Semi-Variance Are Based On Incorrect Definitions of Risk And Hence, Are Inaccurate. Proof: In Finance (and many other fields), Risk has been traditionally and incorrectly defined as the possibility of a return (or reading) that is less than the mean. As explained in this article, the mean is not an effective measure. Furthermore, this definition of risk does not incorporate the following: a) Effect of taxes some investors actively seek losses, in order to maximize their after tax returns. In such instances, C/C/SV/V are grossly inappropriate measures of risk.

b) Derivatives (swaps, options, etc.) derivatives enable investors to transfer/defer risk in ways that render the Mean and the Variance useless as analytical tools. c) Passage of time, etc.. The mean changes over time, and sometimes the changes are continuous. The analysis period may also differ from the duration of the period used in calculating Variance/Covariance/Semivariance. Variance/Covariance/Semi-variance are based on a constant Mean, and thus, are highly inaccurate. d) Short Positions the ability to short (borrow and sell) securities renders the mean-variance framework useless. e) Synthetic Securities the availability of, and ability to create synthetic securities also renders covariance/variance useless. The covariance/variance of synthetic securities sometime differ substantially from that of the actual securities.

Hypothesis-25: Correlation/Covariance/Variance/Semi-Variance Are Inaccurate Because These Measures Dont Incorporate The Effects Of Leverage/Debt. Proof: The effects of leverage include: a) changes in variability and co-movement due to increases in perceived riskiness of asset/variable, b) availability of debt capital for purchase/sale of assets more leverage provides more capital to trade and is likely to result in more variability, and vice versa; c) change in utility gained from the asset return series, d) leverage (eg. margin) can magnify the asset return series and hence, provide misleading information, that will not be laid as availability of capital and interest rates change.

Hypothesis-26: Correlation/Covariance/Variance/Semi-Variance Are Inaccurate Because These Measures Dont Incorporate Transaction Costs. Proof: In financial risk analysis, the effects of transaction costs which can be dominant. In finance, most of the series are actual prices for completed transactions, which dont include the transaction costs. Transaction costs can provide incentives and disincentives for transactions/trades, depending on the asset and the market. In essence the Propensity-To-Complete-A- Transaction is directly related and proportional to the transaction costs. Thus, while C/C/SV/V may indicate a certain level of variability/co-movement, the actual comovement/variability maybe quite different solely because of transaction costs. Transaction costs also affect the

utility gained from variability/co-movement of series, and the utility gained from the asset return series.

Hypothesis-27: Correlation/Covariance/Variance/Semi-Variance Are Inaccurate Because They Dont Incorporate The Effects Of Assymetric Information And Knowledge Differentials. Proof: C/C/SV/V erroneously assumes that the levels of information and knowledge in the market remains constant during the period of analysis this is a major condition for the validity of C/C/SV/V. If the magnitude of information asymmetry changes, then market participant are very likely to revise their beliefs, and the volume of un-completed and completed transactions will change.

Conclusion Correlation/Covariance/Variance/Semi-Variance are very inaccurate and misleading; and dont convey realistic information about variation and risk.

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