Is there evidence of investor herding in the variation of return correlations for individual stocks? In their January 2011 paper entitled “Asymmetric Correlations”, Tarun Chordia, Amit Goyal and Qing Tong investigate when and why return correlations for individual stocks vary over time. At the end of each month, they calculate average pairwise correlations of stocks at a daily frequency over the month. Using daily returns for all NYSE common stocks, along with contemporaneous stock trading data and firm characteristics, from January 1963 through December 2008, they find that:
- Stock correlations rise by 27% on average when market returns are negative. Positive market returns have no significant impact on correlations.
- The driver of the rise in correlations when market returns are negative is an increase in trading volume in small stocks and stocks that have low institutional holdings via small trades. Analysis of order flow confirms that negative market returns trigger coordinated selling of small stocks in small trades. Specifically, when market returns for the first five days of a month are negative, the level of selling in small stocks is elevated for the balance of the month.
In summary, evidence indicates that variation in return correlations among individual U.S. stocks derives from retail trader herding in reaction to negative market returns.
Cautions regarding findings include:
- While findings arguably quantify the implemented sentiment of retail investors, the paper does not address any trading strategy to exploit the information.
- Given changes in the trading environment over the sample period, results may not be stable over time.
