Original Articles

Effects of the market factor on portfolio diversification: the case of market crashes

Published in: Investment Analysts Journal
Volume 44 , issue 1 , 2015 , pages: 71–83

DOI: 10.1080/10293523.2015.994448

Author(s): Cheoljun Eom School of Business, Korea , Jong Won Park College of Business Administration, Korea , Yong H. Kim Carl H. Lindner College of Business, USA , Taisei Kaizoji Graduate School of Arts and Sciences, Japan

Keywords: Markowitz's mean-variance model , Portfolio diversification , property of the market factor , Random matrix theory

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Abstract

This paper investigates empirically the effects of the market factor on the degree of portfolio diversification extracted from Markowitz's mean-variance (MV) model to explore an alternative method for improving the practical usefulness of the model. It controls for various properties included in a correlation matrix of stocks in a portfolio. According to the results based on correlation matrices with and without the property of the market factor, the strength of the market factor has a negative effect on the degree of portfolio diversification in the MV model. This finding is stronger for periods of market crashes. These results suggest that the method for controlling for properties included in the correlation matrix might be a possible solution for enhancing the usefulness of the MV model from a practical perspective.

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