A study led by Tobias Preis, associate professor of behavioural science and finance at Warwick Business School, found shares tend to start behaving the same during a market slump, eliminating the perceived benefits of building a diversified portfolio of stocks.
The study, published in the Scientific Reports journal, analysed the daily closing prices of the 30 stocks forming the Dow Jones Industrial Average from 15 March, 1939, to 31 Dec, 2010.
Dr Dror Kenett of Boston University, who collaborated on the study, said: "The average correlation between these stocks increases at the same rate as market stress. Consequently the diversification effect, which should protect a portfolio, melts away in times of market losses, just when it would be needed most."
Prof Preis, who founded German proprietary trading firm Artemis Capital Asset Management in 2007, argued that this pattern can be used predict ‘diversification breakdown’ in share portfolios and give investors time to spread their money into other asset classes or hedges.
"When financial markets are suffering significant losses our findings could be used to anticipate the increasing lack of diversification in portfolios. This would enable a more accurate assessment of the risk of making losses,” he added.
The expert also claimed that reacting to diversification breakdown could “guide the design of portfolios and contribute to the increased stability of the financial markets”.
Prof Preis also worked with Boston University’s Prof H. Eugene Stanley, ETH Zurich’s Prof Dirk Helbing and Tel-Aviv University’s Prof Eshel Ben-Jacob when working on the Quantifying the Behaviour of Stock Correlations Under Market Stress paper.