The Journal of Empirical Finance has published new research from Scientific Portfolio, an EDHEC venture, “Risk diversification and extreme risk mitigation,” highlighting our empirical work on how different forms of diversification influence portfolio performance and exposure to large losses.

The paper examines how active risk- and holdings-based diversification of equity portfolios affect performance and vulnerability to large losses. Conducting a comprehensive empirical study of US-based funds, we find that risk-based and sector-based diversification significantly reduce active tail risk and the likelihood of extreme losses, without substantially diminishing portfolio performance. We also examine these relationships on an unprecedented large sample of portfolios using a novel methodology that allows the production of portfolios with similar levels of risk, and find that they are robust to several definitions of extreme risk. Our results highlight the practical value of diversification in managing portfolio risk while maintaining competitive performance.

“Diversification and risk reduction are often used interchangeably by investors. In fact they are very different concepts. Understanding the impact of diversification for investors with identical levels of risk has important practical consequences, especially for active investors.”
— Benoit Vaucher, Director of Research, Scientific Portfolio

“Diversification reduces extreme risk across virtually all risk levels, suggesting that enhancing diversification can sometimes replace de-risking as a strategy to mitigate extreme losses.”
— Matteo Bagnara, PhD, Senior Quant Researcher, Scientific Portfolio

Highlights

• Risk-based and sector-based diversification mitigate large portfolio losses.
• Risk-based diversification outperforms other diversification measures in reducing tail risk.
• The marginal benefits of diversification are decreasing: minimizing concentration is not necessary.
• Mitigation effects of risk diversification do not depend on active risk levels.

Get access to the full version of the paper, published in the Journal of Empirical Finance, by completing the form.

Risk diversification and extreme risk mitigation