The concept of correlation between stock markets is much more complex than commonly thought and observations of increased correlations are often the result of different levels of volatility of the research samples rather than a true shift in the fundamental relationship between markets.
"The traditional correlation is a simplistic measure that has all kinds of strange and misunderstood properties. Too much importance is given to this simple number," Hong Kong University of Science and Technology professor of finance Bruno Solnik said.
"We have to be very careful when we talk about correlation. The concept of correlation is only one aspect of interdependency in portfolios," he said.
To get a better idea of the relationship between markets and the effects on investment portfolios, investors have to look at a wider range of factors, including the dispersion of market returns.
Even in times of crisis, when correlations are high, there are still some markets that provide good returns, Solnik said.
Solnik, whose publication 'Global Investments' is a standard text book for certified financial analyst (CFA) programs worldwide, is one of the foremost experts on market correlation.
His research on extreme correlation has shown that correlation increases in bear markets, but not in bull markets.
Solnik argued that the industry should continue to create better models to develop a deeper understanding of how correlation impacts the performance of investment portfolios and how it affects risk mitigation through diversification.
"We can probably improve on the modelling that we are doing," he said. "[But] it is like flying an airplane: when we get a crisis, it is the pilot who counts. It is the quality of the pilot that makes the difference, but that doesn't mean we shouldn't analyse as much as we can," he said.
Solnik, who spoke at a CFA lunch in Sydney this week, also said that correlation between markets increased as these markets become more mature.
"Correlation of developed stock markets tends to increase slowly over time," he said.
But at the same time new markets are continuously emerging, creating new investment opportunities.
"Associated with the slow increase in correlation of developed markets is the expansion of the investment universe. This is a natural evolutionary process," he said.
Solnik pointed out that in the early 1960s, the stock markets of France, Germany and Japan were still emerging markets and were viewed as 'outlandish' at the time.
Therefore, it was important to look at today's emerging markets to capitalise on investment opportunities.
Asked whether Solnik supported an exposure to China he said investors could not afford not to have an exposure.
"My personal view is that you cannot afford to be outside China, directly or indirectly. China is such a big economy; if you don't invest in China and the other guys do you get blown up," he said.
Even though the economic performance of China has not always translated in a rise of the Chinese stock markets, Solnik argued that in the long term gross domestic product growth does lead to market growth.
Although market downturns can influence the short-term returns of equity markets, over the long term country specific economic performance dominates the returns.
"Economic performance is fundamental to the stock market," he said. "Equity prices do revert to economic fundamentals," he said.
