Jerry Vigil

MktNeutral.com (http://www.mktneutral.com/)
September 23, 2010

Finding the free lunch: A review of diversification and correlation

It is often said that diversification is the only free lunch in investing. However, the ability to manage risk
in the stock market through diversification depends on the level of correlation of stock prices to each
other, i.e. how correlated stocks are to one another. If all stocks were perfectly correlated and moved
up and down together in tandem, then diversification would offer no risk management advantage over a
non-diversified portfolio holding a single stock or an index basket of stocks. Risk management in such a
market would be reduced to market timing methods for how to scale in and out of positions as the
market moves up and down. If, on the other hand, the return on any given stock were random and
independent of the movement of all other stocks, then diversification would offer investors a nearly
perfect method for reducing risk. Asset allocation would become a problem of betting on the right
stocks. Some stocks would rise while others would fall, and the portfolio manager’s job would be
simplified to picking the winners and avoiding or shorting the losers.

In the real world, however, investing follows neither of these contrasting scenarios. Stock returns are
not perfectly correlated but they are not independent of one another. Some days the market goes up
sharply and 9 out of 10 listed issues rise. Other days the broad indices are practically flat and some
stocks rise while others fall. Thus, the utility of diversification depends on how correlated stocks are to
each other, and this is why practitioners have developed many methods for quantifying the level of
correlation of stock returns to each other. Knowledge of this correlation level is important to asset
managers because it assists them in making decisions such as whether it is worth the effort to build a
diversified portfolio of stocks rather than to simply invest in index funds.

Time series analysis offers the most widely applied method for quantifying the global level of correlation
in a group of stocks. This method begins with a fixed time interval and stock returns at regular intervals.
For example, five years of monthly stock return data could be used to compute the global correlation of
a group of country specific stock indices as in the paper by Solnik and Roulet. The same approach could
just as easily be applied to long time periods such as years to tick level data on an intraday chart.
Pairwise correlation values are computed across each pair of stocks in the group over the fixed interval
and then these pairwise correlation values are averaged to arrive at the global level of correlation
among the stocks in the group. The average value is usually referred to as the cross sectional correlation
and can be estimated over distinct fixed intervals or over a rolling window period. For example, one
could compute the 90-day cross sectional correlation of the daily returns of all stocks in the S&P 500 by
computing the trailing 90-day correlation of returns for each pair in the S&P 500 and then averaging the
pairwise values to find the cross sectional value.

The time series approach has many limitations. First, each pairwise correlation value is computed
separately, and second, it is difficult to estimate the change in the correlation because each pairwise
value is computed from a moving window in which only one data point changes at each successive time

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step. This problem can be rectified somewhat if the pairwise correlations are computed using formulae
that give more weight to recent data such as exponentially weighted data. However, this solution is
somewhat ad hoc and each pairwise value still depends on many historical data points. It is for this
reason that people began to look for a method of estimating the global level of correlation in a way such
that new estimates are independent of the historical data.

Cross sectional dispersion is a model of global market correlation published by Bruno Solnik and Jaques
Roulet in 2000. This model offers an alternative approach for quantifying the level of correlation of
stocks. The premise of their model is to compute the standard deviation of the returns of a group of
stocks at regular intervals, every month, for example, and to use the standard deviation, which they call
the “dispersion”, as a means to derive an estimate for the “instantaneous correlation” of the group of
assets. They present empirical data that shows that the long term mean of the cross sectional
correlation computed in this manner is very close to the long term value of cross sectional correlation
computed using traditional time series approaches.

The math behind the cross sectional dispersion approach is arguably simpler than that of the time series
approach. To calculate the cross sectional dispersion of a group of stocks, simply compute the standard
deviation of the returns of all stocks in the group over a fixed interval, such as a month. In their paper,
Solnik and Roulet use country specific stock indices at monthly intervals as an example, but the method
can easily be applied to a group of stocks within a sector or a major index at daily or even intraday
periodicities. Now compute the historical value of the volatility for the group of stocks. Let  σc denote
the cross sectional dispersion and  σw denote the volatility of the group of stocks. Then the global level
of correlation is given by the formula:

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ρ=
√ 1+σ 2c /σ 2w
where ρ is the “instantaneous” global level of correlation. Solnik and Roulet derive the formula above
using a series of approximations and assumptions. I will not reproduce the derivation here, but I will
comment on their results and the utility of their model.

Solnik and Roulet use empirical data from country specific stock indices to show that an estimate of the
global level of correlation from their model has a long term average that is approximately equal to the
value of the cross sectional average correlation computed with the time series approach. This is
comforting, given that their approach makes so many approximations and assumptions. Their data
demonstrates cross sectional correlation estimates derived from their dispersion method change more
frequently than a value computed using a rolling window with the time series approach.

The greatest advantage of the cross sectional dispersion approach is that it provides more frequent
estimates of the current global level of correlation in a group of securities than the time series approach.
One of its greatest drawbacks, however, is that the method only offers information about the global
level of correlation in a group of stocks and says nothing about the correlation between different
components within the group. In fact, one of the assumptions of the model is that every stock has the

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same correlation to every other stock in the group. As crude as this assumption may appear, the
empirical data suggest that it is still a very useful way to estimate the level of co-movement in a group of
stocks.

The cross sectional dispersion model offers investors another tool for identifying the utility of
diversification in managing the risk of a portfolio. As up to the minute information becomes more readily
available to people worldwide, and globalization causes world economies to become more
interconnected, it is logical to expect that global stock returns will become more correlated. Investors
now need better tools to identify new opportunities for improving the diversification of their portfolios.
A combination of the traditional time series approach supplemented with the frequent correlation
estimates offered by the dispersion model could be a great way to begin looking for such opportunities.
These quantitative methods are no substitution for old fashioned bottoms up analysis, however.
Investors should always examine the who, what, where, why and how of the underlying businesses into
which they are placing their money and seek to diversify themselves across these fundamental business
dimensions as well.