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Is diversification always good?

6 November 2018

The article at a glance

Probably every Fin 101 class teaches the principle of diversification: do not put all your eggs in one basket. Diversification allows investors …

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Probably every Fin 101 class teaches the principle of diversification: do not put all your eggs in one basket. Diversification allows investors to earn the same return but with possible lower risk. Theoretically, any rational investor would pursue the maximal amount of diversification of their portfolio, and as a consequence, every investor would end up with the same portfolio: market portfolio that only subjects to the systematic risk. In fact, this is one result of the Nobel Prize-winning Capital Asset Pricing Model (CAPM): any efficient portfolio can be replicated with a risk-free Treasury Bill and a market portfolio.

Dr Hui (Frank) Xu
Dr Hui (Frank) Xu

But here comes the paradox: if everyone pursues the diversification to its extreme, the market, as a whole, ends up putting all eggs in the market portfolio. Thus, a disturbance to the market portfolio “as small as the flutter of a butterfly’s wing can ultimately cause a typhoon” in the financial market. And this is corroborated by what occurred during the recent crisis of 2007-2009: many financial institutions holding diversified portfolios experienced serious creditor runs and suffered huge loss.

A paper titled “Diversification and Systemic Bank Panics” by Professor Xuewen Liu at Hong Kong University of Science and Technology formalises such intuition with an economic model. In the model, financial institutions hold similar diversified portfolios, and thus, their strategies in the asset market are clustered and appear to be herding: they either sell their assets at the same time or collectively do not sell. The clustered strategies deteriorate the market liquidity after an adverse shock to the asset market, and thus amplify the initial adverse effect of the shock. The result shows that diversification could make the financial system more vulnerable to the systematic shocks. Although the paper does not explicitly prescribe a remedy for the problem, it advocates active involvement of financial regulators.

The result certainly presents a challenge to the regulators. For one thing, regulators would like each financial institution in the financial system to be sound by asset portfolio diversification; But for another, they would not like each financial institution in the system to have a similar or even same balance sheet: an adverse shock to an individual bank can easily become a shock to the entire financial system. How to guide the financial institutions and keep a balance between diversification and “diversity” puts higher requirement on financial regulators. It calls for more research into the topic as well.