Tuesday, February 21, 2012

Stock Market Correlation and Portfolio Diversification

By Geng Deng, PhD, FRM and Olivia Wang, PhD

It has long been argued that diversification of stock portfolios across country borders is important to reduce investment risk. Although the 2007-2008 financial crisis wreaked havoc on both the developed and the developing world, diversification remains a central pillar of modern portfolio theory. The following figure from World Federation of Exchanges shows the value of several stock indexes starting from 1992 (Full Disclosure: No data available for Tehran SE/TEPIX in 2008, 2009 and 2010). The selected index as well as the stock exchange which publishes it is also listed.

        Figure1: Stock Index Levels between 1992 and 2010

The overall trend of the indexes is common: a relatively stable growth during 2002 to 2007, and a precipitous fall during the peak of the financial crisis. This pattern is more precisely reflected in the correlation of the annual returns of the seven indexes. Figure 2 shows the average of the pair-wise correlation computed using data from the previous ten-year-period for each given year. For example, the average correlation for year 2002 is obtained by first computing the correlation of annual returns of any two stock indexes from the seven indexes shown in Figure 1 over the period of 1993 to 2002. The average correlation is simply the arithmetic mean of all the pairwise correlations.

Figure 2: Evolution of Average Correlation

Starting from 2002, the average correlation increased from a moderate 0.25 to a striking 0.80. Globalization in both international trade and finance almost certainly contributes significantly to this increase (and correlations tend to increase during tumultuous periods such as 2007 and 2008). But if you believe that as the memory of the recent crisis fades away the global equity market will return to more tranquil period, diversification in your portfolio may still be an option worth exploring.

Interestingly, a recent NBER paper finds that even for investors who are supposed to be sophisticated enough to understand the complications involved in investing in the global markets, such as mutual fund managers, the degree of diversification is still not high. (A blog post written by the authors could be found here). In other words, the “Home Equity Bias Puzzle”, or “Lack of Diversification Puzzle” that has troubled economists for years is still present. The increased correlation of the global equity market will not completely explain this puzzle away, but at least it adds a new factor to the debate.

1 comment:

  1. It continues to amaze me that supposedly 'sophisticated' investors, such as the mutual fund managers mentioned in the last paragraph, fails to properly diversify and also continue to exhibit 'home bias.' I talk about this in my best-selling book and am pleased to provide complimentary links to to relevant chapters here:

    Home bias: http://bit.ly/vqunLV
    Diversification: http://bit.ly/vxDo6v


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