On financial market correlation structures and diversification benefits across and within equity sectors

TL;DR

This study analyzes 20 years of US stock data to understand how market correlation structures affect diversification benefits, especially during crises, and proposes methods to optimize equity portfolio diversification.

Contribution

It introduces graph-theoretic diagnostics and eigenvalue analysis to quantify market collectivity and guides optimal sector-based diversification strategies.

Findings

Financial crises show high collective market behaviour.

Diversification benefits decrease during crises due to increased collectivity.

A portfolio of 36 stocks across 9 sectors offers optimal diversification.

Abstract

We study how to assess the potential benefit of diversifying an equity portfolio by investing within and across equity sectors. We analyse 20 years of US stock price data, which includes the global financial crisis (GFC) and the COVID-19 market crash, as well as periods of financial stability, to determine the `all weather' nature of equity portfolios. We establish that one may use the leading eigenvalue of the cross-correlation matrix of log returns as well as graph-theoretic diagnostics such as modularity to quantify the collective behaviour of the market or a subset of it. We confirm that financial crises are characterised by a high degree of collective behaviour of equities, whereas periods of financial stability exhibit less collective behaviour. We argue that during times of increased collective behaviour, risk reduction via sector-based portfolio diversification is ineffective. Using the degree of collectivity as a proxy for the benefit of diversification, we perform an extensive sampling of equity portfolios to confirm the old financial adage that 30-40 stocks provide sufficient diversification. Using hierarchical clustering, we discover a `best value' equity portfolio for diversification consisting of 36 equities sampled uniformly from 9 sectors. We further show that it is typically more beneficial to diversify across sectors rather than within. Our findings have implications for cost-conscious retail investors seeking broad diversification across equity markets.