Identifying Business Sectors from Stock Price Fluctuations

TL;DR

This paper uses cross-correlation matrices of stock price fluctuations over different periods to identify stable business sectors, which can aid in risk-aware investment strategies.

Contribution

It introduces a method to identify business sectors from stock correlations that are stable over time, using eigenvector analysis of correlation matrices.

Findings

Eigenvectors correspond to business sectors.

Identified sectors are stable over years.

Sectors useful for risk management in investments.

Abstract

Firms having similar business activities are correlated. We analyze two different cross-correlation matrices C constructed from (i) 30-min price fluctuations of 1000 US stocks for the 2-year period 1994-95 and (ii) 1-day price fluctuations of 422 US stocks for the 35-year period 1962-96. We find that the eigenvectors of C corresponding to the largest eigenvalues allow us to partition the set of all stocks into distinct subsets. These subsets are similar to conventionally-identified business sectors, and are stable for extended periods of time. Using a set of coupled stochastic differential equations, we argue how correlations between stocks might arise. Finally, we demonstrate that the sectors we identify are useful for the practical goal of finding an investment which earns a given return without exposure to unnecessary risk.