Diversification Meltdown or Just Fat Tails?

Abstract

An increase in correlation during turbulent market conditions implies a reduction in the benefits arising from portfolio diversification. Unfortunately, it is exactly then that these benefits are most needed. We investigate the robustness of recent empirical results that indicate correlation breakdown by deriving theoretical truncated and exceedance correlations using alternative distributional assumptions. Analytical results show that the empirical meltdown in diversification could be a result of assuming conditional normally distributed returns. When assuming a popular alternative distribution model - the bivariate Student-t distribution - we find significantly less support for diversification meltdown.