There are some misconceptions about risk management and blaming this concept for not protecting investors in 2008 merely signals a lack of proper understanding of the true nature of risk diversification, says chiefs at the EDHEC-Risk Institute.
Recent EDHEC-Risk research shows that while diversification is most effective in extracting risk premia over reasonably long investment horizons, hedging and insurance are better suited for loss control over short horizons. Furthermore, new forms of investment solutions should rely on the use of improved performance-seeking and liability-hedging building-block portfolios, as well as on the use of improved dynamic allocation strategies.
“Since the global financial crisis of 2008, improving risk management practicesmanagement of extreme risks, in particularhas been a hot topic,” says Nol Amenc, Director, and Lionel Martellini, Scientific Director at EDHEC-Risk Institute. “The postmodern quantitative techniques suggested as extensions of mean-variance analysis, however, exploit diversification as a general method. Although diversification is most effective in extracting risk premia over reasonably long investment horizons and is a key component of sound risk management, it is ill-suited for loss control in severe market downturns.”
“Hedging and insurance are better suited for loss control over short horizons. In particular, dynamic asset allocation techniques deal efficiently with general loss constraints because they preserve access to the upside. Diversification is still very useful in these strategies, as the performance of well-diversified building blocks helps finance the cost of insurance strategies,” they add.
The variations of correlation are important not only across markets but also over time; in the short run, then, relying on diversification alone can be dangerous, say EDHEC-Risk Institute. Over longer horizons, Jan and Wu (2008) argue that diversified portfolios on the mean-variance efficient frontier outperform inefficient portfolios, an argument that adds to the debate that time alone may not diversify risks.
“The limitations of diversification mean that, in certain market conditions, it can fail dramatically,” says Amenc and Martellini. “Using a conditional correlation model, Longin and Solnik (2001) conclude that correlations of international equity markets2 increase in bear markets. In severe downturns, then, diversification is unreliable. Furthermore, it is generally incapable of dealing with loss control. So enhancing the quantitative techniques behind it by using more sophisticated risk measures and distributional models can lead to more effective diversification but not to substantially smaller losses in crashes. Loss control can be implemented in a sound way only by going beyond diversification to hedging and insurance, two other approaches to risk management.”
(LB)