Bridge over ocean
1 January 2015 CFA Institute Journal Review

Diversification and Systemic Risk (Digest Summary)

  1. Isaac T. Tabner, CFA

Portfolio diversification seems to lower risk for individual investors, but it increases systemic risk. The contagion externality arises because investors have common holdings in their portfolios that facilitate the transmission of systemic shocks via constrained selling and portfolio rebalancing. This process creates endogenous covariance between assets and investors, an externality that can be mitigated by increasing the distance between portfolio holdings.

What’s Inside?

To explain the risk of portfolio diversification, the author uses the analogy of a group of mountain climbers roped together. Individual climbers are safer, but the group as a whole is more likely to be destroyed by the fall of a single climber. To quantify this contagion externality, the author uses network analysis. A home-biased setting is assumed, where investors acquire assets that have a low informational distance from those that they already own. Investors can minimize portfolio variance by seeking new assets that are far from their existing holdings in the financial network. Systemic risk is reduced more when the number of available assets is higher because the maximum distance within the financial network is greater.

How Is This Research Useful to Practitioners?

Investors aiming to create diversified portfolios should avoid home bias and seek portfolio holdings that are “far” from each other in the financial network. In this context, home bias refers to investors’ favoring assets that are close to those they already own, perhaps being motivated by perceived informational and transactional efficiencies.

Intuitively, this recommendation seems to imply that investors should not replicate the portfolios of other investors with similar liabilities, liquidity, risk preferences, and information sets. To do so runs the risk that events that trigger forced selling for one investor are replicated across other, similar investors, resulting in fire sales among asset holdings that are “close” in the financial network.

The author cites studies indicating that informational distance is negatively correlated with bilateral investment holdings. Home-biased investors forgo diversification benefits and acquire avoidable endogenous risk. As the number of investable securities increases and home bias is reduced, diversification improves both at the individual investor level and at the macro systemic level.

Although this research is highly applicable to equity holdings, the author also discusses the contagion in terms of the asset-backed securities (ABS) crisis of 2008. As risk-based capital requirements are increasing and discussions of systemically important institutions increase, it is important to measure the probability of failure and appropriate diversification of investors and banking institutions. This analysis is especially important when assets are concentrated in the portfolios of a small number of highly levered investors.

How Did the Author Conduct This Research?

The author sets up a contagion model composed of N constrained portfolio investors who are forced to sell in response to negative wealth shocks. Forced sales lower prices, further tightening the constraints and thus triggering further forced sales. The N investors are within the same home-biased network, and all have the same pattern of asset holdings. The result is that the covariance between assets and investors that depends on distance can be derived analytically.

Finally, statistical analysis is applied to the multivariate distribution of portfolio losses to determine the likelihood that a given number of investors will fail for a given level of diversification. In the author’s setup, price shocks are influenced by interactions of two categories of investors: long-term (LT) investors who are required to sell or rebalance following shocks and medium-term (MT) investors who buy assets from the constrained LT investors. Price shocks are readily mitigated when demand from MT investors is high following initial shocks. Convergent investors buy below and sell above fundamental value, and a mean reversion factor also serves to move prices back toward fundamental value and away from contagion and panic selling.

In this situation, it is difficult for a panic to occur unless sales on a given market exceed 5%; moderate panic is triggered when sales on a given market exceed 1%; and easy panic requires sales of only 0.5%. In the moderate and easy panic setting, the author finds that high levels of diversification and no diversification are preferable to moderate levels, thus suggesting that there is a critical diversification threshold above which diversification is desirable and below which zero diversification is preferable from the perspective of the market as a whole.

Abstractor’s Viewpoint

The author creates a theoretical structure that applies network analysis to investigate volatility transmission mechanisms through the variance–covariance matrix of security returns. The approach provides insights into the transmission of systemic shocks and also provides some hints as to how portfolio managers can make both their individual portfolios and the financial system as a whole more resilient. The impact of the research on the way investors behave may be enhanced if the author were to devote further effort toward articulating how investors should structure their portfolios to increase the “distance” between individual holdings and how regulators can facilitate such a process.

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