Diversification effects between stock indices

Abstract

During the World Financial Crisis it became obvious that classical models of portfolio theory significantly under-estimated risks, especially with regard to stocks. Instabilities of correlations and volatilities, the relevant parameters characterizing risk, led to overestimation of diversification effects and consequently to under-estimation of risks. In this article, we analyze diversification effects concerning stocks during different market periods of the previous decade. We show that parameters and risks significantly change with market periods and find that the impact of fluctuations and estimation errors is 5 times larger for volatilities than for correlations. Moreover, it turns out that diversification between sectors is more efficient than diversification between countries.