A quantitative analysis of 72 years of financial data from the Dow Jones Industrial Average reveals that in times of financial crisis, stocks start to move in more synchronised fashion, increasing the risk of a stock portfolio. The research is published in the journal Scientific Reports this week.
Understanding correlations in complex systems, including financial systems, is important in the face of turbulence, such as in a financial crisis. Financial traders try to reduce the inherent risk of holding only one stock by building portfolios, which carry a lower risk, mainly because individual stocks do not tend to experience daily gains and losses in a completely synchronised manner. Tobias Preis and colleagues analyzed daily closing prices of the 30 stocks that form the Dow Jones Industrial Average, from March 1939 to the end of 2010. They find that the diversification effect that should protect a portfolio breaks down during times of market losses, just when this protection would be most critical.
The findings could be used to help anticipate diversification breakdowns in stock portfolios when financial markets are suffering significant losses, allowing a more accurate assessment of the potential risks.