In recent months, much has been made about elevated correlations in the stock markets. Everything seems to go up and down in tandem. This has been a nightmare for investors trying to diversify their portfolios.However, correlations have actually been receding lately, reports the Wall Street Journal’s Jason Zweig. But it sure doesn’t feel like it, given the recent market volatility.
Why, then, have the markets felt as if they were all glued together? A recent study by a team of neuroscientists may offer a partial answer.
Calculating correlations might seem like a task that could be carried out only in the most “rational” areas of the brain. But it turns out that humans process relationships among variables in a region of the brain called the insula, which processes visceral reactions like disgust and pain. The study also suggests that people learn best about correlation by focusing on long-term trends or sequences, rather than on isolated, salient events.
Thus, a handful of data points like the market moves of the past few days can distort our impressions of how correlated the world’s financial assets have become. Only by comparing today’s correlations with those of the past can you realise they are no higher than they have been for much of the last few years.