Role of Diversification Risk in Financial Bubbles

TL;DR

This paper extends the JLS model by incorporating the Zipf factor to analyze diversification risk during financial bubbles, applied to Chinese stock market bubbles, revealing how concentration of gains varies with market conditions.

Contribution

The paper introduces the Zipf factor into the JLS bubble model, providing new insights into diversification risk and investor behavior during bubbles.

Findings

Zipf factor is significant in bubble 1, indicating concentrated gains on large firms.

In bubble 2, the Zipf factor is marginally relevant, showing more gains on small firms.

The model explains differences in investor behavior and market concentration during two Chinese bubbles.

Abstract

We present an extension of the Johansen-Ledoit-Sornette (JLS) model to include an additional pricing factor called the "Zipf factor", which describes the diversification risk of the stock market portfolio. Keeping all the dynamical characteristics of a bubble described in the JLS model, the new model provides additional information about the concentration of stock gains over time. This allows us to understand better the risk diversification and to explain the investors' behavior during the bubble generation. We apply this new model to two famous Chinese stock bubbles, from August 2006 to October 2007 (bubble 1) and from October 2008 to August 2009 (bubble 2). The Zipf factor is found highly significant for bubble 1, corresponding to the fact that valuation gains were more concentrated on the large firms of the Shanghai index. It is likely that the widespread acknowledgement of the 80-20 rule in the Chinese media and discussion forums led many investors to discount the risk of a lack of diversification, therefore enhancing the role of the Zipf factor. For bubble 2, the Zipf factor is found marginally relevant, suggesting a larger weight of market gains on small firms. We interpret this result as the consequence of the response of the Chinese economy to the very large stimulus provided by the Chinese government in the aftermath of the 2008 financial crisis.