What Caused the Increase in Correlation?

Correlation in the stock market refers to the statistical relationship between the price movements of different stocks or assets. It measures the degree to which these price changes tend to occur together or in opposite directions over a specific period. Positive correlation implies that stocks move in the same direction, with price increases or decreases happening simultaneously. Conversely, a negative correlation signifies that stocks move in opposite directions.

Correlation is a crucial concept for portfolio diversification, as assets with low or negative correlation can potentially help mitigate risk by reducing the impact of a single asset's poor performance on the overall portfolio. Investors use correlation analysis to build well-balanced portfolios that aim to achieve a combination of assets that respond differently to market fluctuations, enhancing the potential for stable returns in varying market conditions.

Reference [1] examined the correlation in the global equity market over a long period of time. The authors looked for the cause of the increase in correlation,

We conclude that greater openness has been the single most important cause of growing correlations during the last quarter of a century, though increasingly correlated economic fundamentals also matter.

They also discussed the implication of the increased correlation,

If our argument that capital account openness itself raises covariances is correct, it implies that diversification benefits in the future cannot be as high as many scholars writing in the 1960s predicted. Rather, as more and more countries open up to outside capital, the benefits from diversification are likely to decline. The “home bias puzzle” will be commensurately smaller. It is still possible that investors who are among the first to put their money into newly open markets can benefit from uncorrelated returns for a while. Further, high returns appear to follow liberalizations (Peter B. Henry 2000). Yet over the long run, diversification benefits may be small, provided a significant number of investors chase them.

In short, the growing openness and interconnectedness of financial markets have led to an increase in correlation, which, in turn, has diminished the diversification benefits traditionally sought from investing across multiple assets and countries.

Our question is: will we witness a similar rise in the correlation between different types of trading strategies, e.g. mean reversion and trend following?

Let us know what you think in the comments below or in the discussion forum.

References

[1] Quinn, Dennis P., and Hans-Joachim Voth. 2008. A Century of Global Equity Market Correlations. American Economic Review, 98 (2): 535-40.

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