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When does diversification increase risk?

Written By: Jason Shafrin - Aug• 11•11

Why did the financial crisis occur?  One reason may be due to too much institutional diversification.  George Sugihara explains how even when individual institutions diversify, system-wide risk can increase exponentially.

Leading up to the crash, there was a marked increase in homogeneity among institutions, both in their revenue-generating strategies as well as in their risk-management strategies, thus increasing correlation among funds and across countries—an early warning. Indeed, with regard to risk management through diversification, it is ironic that diversification became so extreme that diversification was lost: Everyone owning part of everything creates complete homogeneity. Reducing risk by increasing portfolio diversity makes sense for each individual institution, but if everyone does it, it creates huge group or system-wide risk.

More details below.

Can you identify when a tipping point will occur?  Maybe:

A key phenomenon known for decades is so-called ‘critical slowing’ as a threshold approaches. That is, a system’s dynamic response to external perturbations becomes more sluggish near tipping points. Mathematically, this property gives rise to increased inertia in the ups and downs of things like temperature or population numbers—we call this inertia “autocorrelation”—which in turn can result in larger swings, or more volatility.

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  1. […] 5.) When Does Diversification Lead to Risk? […]

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