Typically, portfolio diversification is achieved using two main strategies: investing in different classes of assets thought to have little or negative correlation or investing in similar classes of assets in multiple markets through international diversification. While these two strategies have both solid theoretical justification and strong empirical evidence exists as to the benefits, investors must be aware that correlation is dynamic and varies over time, changing the amount of portfolio diversification within a given asset allocation.
In particular, a number of studies document that correlation between equity returns increases during bear markets and decreases when stock exchanges rally (see, among others, Erb, Harvey and Viskanta, (1994), De Santis and Gerard, (1998), Ang and Bekaert, (2001), Das and Uppal, (2001), and Longin and Solnik, (2001)).
Over the past 20 years, a tremendous literature has developed where the dynamics of the covariance of assets has been explored, although the primarily focus has been on univariate volatilities and not correlations (or covariances). Among other regularities, (conditional) estimates of the second moments of equities often exhibit the so-called “asymmetric volatility” phenomenon, where volatility increases more after a negative shock than after a positive shock of the same magnitude; in fact, evidence has been proffered that volatility may fail to increase or even fall subsequent to a positive shock for certain assets. Asymmetric effects have also been recently found in conditional correlations, although the economic reasoning behind these effects has not been widely researched.
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