# Risk Rules Don't Escape Post-Hoc Fitting Either — A 189-Month Test of Correlation and Volatility Caps
- Source: FoldAlpha Research (https://app.foldalpha.com/en/research/correlation-cap-oos) · Published: 2026-09-03 · Series: Myth Testing 15

In [Article 9](/en/research/backtest-self-deception) we performed an autopsy on how a return signal (the theme sleeve) was manufactured by hindsight selection.
This time it is a **risk rule**. Rules that reduce losses draw less suspicion than return signals — which makes them more dangerous.

## How the Rule Was Born

In July 2026, the US momentum strategy we were running posted -22.5% in a single month ([Article 10](/en/research/momentum-crash-invoice)).
Right afterward, this rule was proposed: pick stocks in ranking order, but **skip any stock whose 126-day daily-return correlation with an already-selected stock is 0.5 or higher,
and skip any stock whose annualized volatility exceeds 100%.** Reconstructing that July, -18.5% shrank to -8.0%.

The problem is obvious. The thresholds 0.5 and 100% were set by looking at July. Working well in July is not a test — it is a definition.

## Test Method

- Using the production pipeline's ranking function as-is, monthly rankings were reconstructed for **189 months** from 2010-12 to 2026-08 (current S&P 500 constituents, survivorship bias present — identical across all arms)
- Top 10 stocks equal-weighted with monthly rebalancing vs. 10 stocks after applying the caps
- 8 threshold variants (correlation 0.4/0.5/0.6, volatility on/off, 0.8/1.2) are **all reported**
- Key window: the period before the rule was created = a genuine out-of-sample

## Results — The 158 Months Before the Tuning (2010-12 to 2024-01)

| | Cumulative | Monthly avg | Monthly σ | IR | Worst month | MDD |
|---|---|---|---|---|---|---|
| S&P500 (SPY) | 415% | 1.13% | 4.2% | 0.94 | -12.5% | -24% |
| No cap (current) | **4,798%** | 2.72% | 6.8% | 1.38 | -19.8% | -29% |
| Corr 0.5 + vol 1.0 (original) | 3,573% | 2.47% | 5.8% | 1.47 | **-19.4%** | **-28%** |

- **It did not block the tail.** Over 16 years, the worst month went -19.8 → -19.4 and MDD -29 → -28. The large drawdowns of 2011, 2015–16, 2018 and 2020 were **beta crashes** in which the whole market fell, and cutting cross-stock correlation leaves market exposure untouched. A correlation cap only blocks **concentrated crashes** like July, and there are only a handful in 16 years.
- **Risk-adjusted, it is neutral.** IR +0.09 sits inside the 1.36–1.48 spread across the 8 variants. Even in the in-sample window where the rule was created (2024-02 to 2026-06), IR went 1.60 → 1.31 — **actually worse**. That one July month was the whole story.
- **Half the compounding.** Continually replacing top-ranked stocks with lower-ranked ones dilutes momentum every month. It also missed the August rebound (cap -6% vs. no cap +2%).
- The volatility cap (100%) **almost never triggered and was therefore inert**. The entire effect came from the correlation cap.

## What This Result Says

- Risk rules get post-hoc fitted too. The framing "it reduces losses" loosens the testing standard
- You must first ask which kind of drawdown a rule blocks. This rule is for concentrated crashes only, and most of our losses were beta crashes
- For the same purpose (tail defense), a rule that fires only in extreme regimes has a better cost structure than one that pays a cost at all times — we kept the already-deployed market-overheating guard and did not adopt this rule

## Limits

- Because it is based on current constituents, the absolute figures are biased upward. Only cross-arm comparisons are valid
- For the 2010–2021 window, financial data is unavailable, so the quality feature is treated as neutral and the ranking is momentum-only (same convention as the production engine)

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This article documents tests on historical data for informational purposes only. It is not investment advice or a recommendation to buy or sell any security. Past test results do not guarantee future returns.