One of the many vexations equity investors have is that shares even in apparently very different companies often move up and down together, with the result that it's hard to spread risk by diversifying across them. But why are they so correlated? In part, it's because equity traders are gamblers, so shares move together as their taste for a bet rises and falls.
This is the finding of a new paper by Alok Kumar at the University of Miami. He established this rather ingeniously by exploiting three facts. First, investors tend disproportionately to hold shares in firms' whose headquarters are near where they live; this is the so-called home bias. Secondly, some stocks - generally low-priced, volatile ones - are more attractive to gamblers. Thirdly, in the US there are regional differences in social norms towards gambling which are correlated with the ratio of Catholics to Protestants in the area: Catholics, traditionally, are less censorious about betting than Protestants.
Professor Kumar shows that lottery-type stocks whose firms are based in Catholic areas - where gambling is more tolerated - tend to be more highly correlated with each other than either more stable stocks based in the same area or than lottery-type stocks based in Protestant areas. This is true even controlling for things such as size and value, which should generate correlations anyway. This, he says, suggests that shares are correlated in part because some investors like a gamble.
This matters, because it could be that gambling is becoming a bigger part of the market. One fact hints at this - that trading volume has soared. Figures from the London Stock Exchange show that equity turnover in December was three times what it was in December 2004 and vastly higher than during the tech bubble of 1998-99.
In theory, increased volumes might be a rational response to the greater availability of information. However, research by Ilia Dichev at Emory University in Atlanta casts doubt upon this. He shows that trading volume is strongly associated with increased volatility; if it were a sign of the smart money buying, one would expect the opposite, that volume would reduce volatility.
He established this by some natural experiments. If firms have two different classes of share (voting and non-voting, say), it is the more heavily traded stock that is more volatile. And when a stock joins the S&P 500, or moves from the Nasdaq to NYSE, its trading volume and volatility both rise. In all these cases, there's no fundamental news about the companies to warrant the extra trading and volatility. The message, says professor Dichev, is that "trading creates its own volatility".
All of which leaves us with a depressing possibility - that at least some shares are becoming more highly correlated because an increased desire to bet on markets rather than invest for the long term has produced an explosion of trading activity that is not justified by company fundamentals.