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Two-faced property of a market factor in asset pricing and diversification effect

Cheoljun Eom

Physica A: Statistical Mechanics and its Applications, 2017, vol. 471, issue C, 190-199

Abstract: This study empirically investigates the test hypothesis that a market factor acting as a representative common factor in the pricing models has a negative influence on constructing a well-diversified portfolio from the Markowitz mean–variance optimization function (MVOF). We use the comparative correlation matrix (C-CM) method to control a single eigenvalue among all eigenvalues included in the sample correlation matrix (S-CM), through the random matrix theory (RMT). In particular, this study observes the effect of the largest eigenvalue that has the property of the market factor. According to the results, the largest eigenvalue has the highest explanatory power on the stock return changes. The C-CM without the largest eigenvalue in the S-CM constructs a more diversified portfolio capable of improving the practical applicability of the MVOF. Moreover, the more diversified portfolio constructed from this C-CM has better out-of-sample performance in the future period. These results support the test hypothesis for the two-faced property of the market factor, defined by the largest eigenvalue.

Keywords: Market factor; Asset pricing; Portfolio diversification; Correlation matrix; Stock network; Mean–variance optimization function (search for similar items in EconPapers)
Date: 2017
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Handle: RePEc:eee:phsmap:v:471:y:2017:i:c:p:190-199