In risk management, diversification denotes the relative reduction of total risk by the aggregation of individual risks that are not identical (and hence will not all materialize in the same way). The reduction is relative to the nominal exposure of the total risk, which is increasing with the aggregation.
Diversification obtains because the uncertainties comprising the pool of risks will typically have multiple causes and underlying reasons (will have some measure of independence). Therefore the outcomes / realizations will not be identical for all risks.
Hence diversification is very closely linked to the concept of dependence or to the degree of correlation between risks, namely the likelihood of a given risk materializing given the realization of another risk.
The limits of diversification
- In the one theoretical extreme, if risks are perfectly dependent then the addition will only scale up the total risk (zero diversification).
- In the other theoretical extreme, if risks are perfectly anti-correlated, the addition will eliminate all risk.
- Most commonly the addition of "all" of risks of the same type leads to the maximum achievable relative reduction (maximum diversification benefit). The residual of risk depends on the details of the
risk interaction and will vary
Domains of application
Diversification is a core consideration across different areas of risk management, the most prominent ones being areas where the management of risks is actually central to the business model rather than incidental such as
- Market risk, in the context of managing a portfolio of financial assets with readily observed trading prices
- Credit risk, in the context of managing a credit portfolio to a range of counterparties
- Insurance risk, in the context of managing a portfolio of insurance policies covering diverse risks
Other types of risks may also exhibit diversification phenomena (e.g., business or operational risk) but in these areas the concept and applications of diversification are significantly less developed
The reality of diversification will typically be reflected in some way in the Limit framework, in the sense that in a Hierarchical Limit Structure higher (more aggregated) nodes will have limits that are lower than the sum of the sub-units
The quantification of diversification is primarily attempted in the portfolio management areas mentioned above and is indeed just a subset of quantitative portfolio management.
The basis for quantification tends to be the empirical basis of past risk realization, without, though the lack of more theoretical or subjective approaches.
Issues and Challenges
In a crisis all correlations approach 1
In traded markets context, where the "risk" is essentially driven by the balance of views of the traders that constitute the market, evidence based on long empirical can become irrelevant if the market seizes to be liquid.
After the financial crisis of 2008 a widely used expression "risk-on / risk-off" suggests a market psychology behind all traded assets dominated by a single key risk factor, hence eliminating any diversification benefit
Similarly, in credit context, severe indebtedness and economic depression can lead to societal or regulatory re-evaluation of lending practices and exposures, effectively annulling the legal framework that was used prior to the crisis.
These examples suggest that the mechanism of diversification is vulnerable to certain types of severe risks.
Diversification versus Transaction Costs and Model Risk
The aggregation of risks is not without potential penalties as it may
- be performed without the commensurate increase of risk analysis, thereby increase model risk
- increase transaction costs beyond the benefit obtained
On the matter of model risk, the risk reducing nature of diversification means that its extent (and benefits) can be exaggerated for the purpose of justifying increased trading, volumes, leverage etc. Such exaggeration is typically based on lack of a sufficient empirical basis pointing to the contrary, together with plausible forward looking argumentation. Model risk - in this context - is the source of much common wisdom of "placing all your eggs in one basket and watching it closely".
A diversified portfolio may also mean higher costs in fees and other transaction costs which are deducted upfront but may or may not lead to materialized risk reduction benefits.