Quantifying the Behavior of Stock Correlations Under Market Stress

Scientific Reports, Vol. 2, 2012, DOI:10.1038/srep00752

5 Pages Posted: 2 Nov 2012

See all articles by Tobias Preis

Tobias Preis

Data Science Lab, Behavioural Science, Warwick Business School; The Alan Turing Institute

Dror Y. Kenett

Financial Industry Regulatory Authority (FINRA); Johns Hopkins University

H. Eugene Stanley

Boston University - Center for Polymer Studies

Dirk Helbing

ETH Zürich - Department of Humanities, Social and Political Sciences (GESS)

Eshel Ben-Jacob

Tel Aviv University (Deceased)

Date Written: 2012

Abstract

Understanding correlations in complex systems is crucial in the face of turbulence, such as the ongoing financial crisis. However, in complex systems, such as financial systems, correlations are not constant but instead vary in time. Here we address the question of quantifying state-dependent correlations in stock markets. Reliable estimates of correlations are absolutely necessary to protect a portfolio. We analyze 72 years of daily closing prices of the 30 stocks forming the Dow Jones Industrial Average (DJIA). We find the striking result that the average correlation among these stocks scales linearly with market stress reflected by normalized DJIA index returns on various time scales. Consequently, the diversification effect which should protect a portfolio melts away in times of market losses, just when it would most urgently be needed. Our empirical analysis is consistent with the interesting possibility that one could anticipate diversification breakdowns, guiding the design of protected portfolios.

Keywords: Financial Markets, Correlation Breakdown, Portfolio Theory, Stock Market, Dow Jones Industrial Average, State-Dependent Correlations, Diversification, Stock Market Crash

JEL Classification: A10, B40, C10, C20, C22, C53, C90, D70, D79, D83, J10, J11, O40, O47

Suggested Citation

Preis, Tobias and Kenett, Dror Y. and Stanley, H. Eugene and Helbing, Dirk and Ben-Jacob, Eshel, Quantifying the Behavior of Stock Correlations Under Market Stress (2012). Scientific Reports, Vol. 2, 2012, DOI:10.1038/srep00752, Available at SSRN: https://ssrn.com/abstract=2170038

Tobias Preis (Contact Author)

Data Science Lab, Behavioural Science, Warwick Business School ( email )

University of Warwick
Coventry, CV4 7AL
United Kingdom

HOME PAGE: http://www.tobiaspreis.com

The Alan Turing Institute ( email )

British Library, 96 Euston Road
London, NW12DB
United Kingdom

HOME PAGE: http://https://www.turing.ac.uk/people/researchers/tobias-preis

Dror Y. Kenett

Financial Industry Regulatory Authority (FINRA) ( email )

Washington, DC
United States

Johns Hopkins University ( email )

Baltimore, MD 20036-1984
United States

H. Eugene Stanley

Boston University - Center for Polymer Studies ( email )

Boston, MA 02215
United States

Dirk Helbing

ETH Zürich - Department of Humanities, Social and Political Sciences (GESS) ( email )

ETH Zurich - Swiss Federal Institute of Technology
Clausiusstrasse 50
Zurich, 8092
Switzerland

HOME PAGE: http://www.coss.ethz.ch

Eshel Ben-Jacob

Tel Aviv University (Deceased)

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