How Homogeneous Diversification in Balanced Investment Funds Affects Portfolio and Systemic Risk

Abstract:     
The last financial crisis sheds dramatically light on the instability threatened by systemic risk. In this regard no common view appears to exist on the definition, the measurement and real impact on financial system. This paper aims to analyze the relation between systemic risk and portfolio diversification, highlighting the differences between heterogeneous and homogeneous diversification. Diversification is generally accepted to be the main tool for reducing idiosyncratic or portfolio-specific financial risk, but the homogeneous diversification produces also effects on systemic risk. The research consists of three steps to investigate how diversification affects the two components of portfolio risk: (i) systematic, and (ii) idiosyncratic risk. Through the impact on the level of portfolios allocation homogeneity, we assess how (iii) the diversification affects systemic risk. The empirical research implements the estimation strategy through balanced investment funds data, examining the change in asset allocation and the impact on the measures of different types of risk. The results suggest that funds' portfolio diversification reduces at the same time the portfolio-specific risk increasing the likelihood of a simultaneous collapse of financial institutions-given that a systemic event occurs.

Number of Pages in PDF File: 29

Keywords: Portfolio diversification, Risk, Asset allocation heterogeneity, Market crash

JEL Classification: G11, G17

working papers series