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Portfolio Diversification Effects of Downside Risk

Author

Listed:
  • Namwon Hyung

    (Seoul City University)

  • Casper G. de Vries

    (Faculty of Economics, Erasmus Universiteit Rotterdam)

Abstract

Risk managers use portfolios to diversify away the unpriced risk of individual securities. In this article we compare the benefits of portfolio diversification for downside risk in case returns are normally distributed with the case of fat-tailed distributed returns. The downside risk of a security is decomposed into a part which is attributable to the market risk, an idiosyncratic part, and a second independent factor. We show that the fat-tailed-based downside risk, measured as value-at-risk (VaR), should decline more rapidly than the normal-based VaR. This result is confirmed empirically. This discussion paper has resulted in a publication in the Journal of Financial Econometrics . (2005, 3(1), 107-125.)

Suggested Citation

  • Namwon Hyung & Casper G. de Vries, 2005. "Portfolio Diversification Effects of Downside Risk," Tinbergen Institute Discussion Papers 05-008/2, Tinbergen Institute.
    • Handle: RePEc:tin:wpaper:20050008
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    References listed on IDEAS

    as
    1. Gourieroux, C. & Laurent, J. P. & Scaillet, O., 2000. "Sensitivity analysis of Values at Risk," Journal of Empirical Finance, Elsevier, vol. 7(3-4), pages 225-245, November.
    2. Jansen, Dennis W. & Koedijk, Kees G. & de Vries, Casper G., 2000. "Portfolio selection with limited downside risk," Journal of Empirical Finance, Elsevier, vol. 7(3-4), pages 247-269, November.
    3. Jansen, Dennis W & de Vries, Casper G, 1991. "On the Frequency of Large Stock Returns: Putting Booms and Busts into Perspective," The Review of Economics and Statistics, MIT Press, vol. 73(1), pages 18-24, February.
    4. Arzac, Enrique R. & Bawa, Vijay S., 1977. "Portfolio choice and equilibrium in capital markets with safety-first investors," Journal of Financial Economics, Elsevier, vol. 4(3), pages 277-288, May.
    Full references (including those not matched with items on IDEAS)

    Citations

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    Cited by:

    1. Chen Zou, 2009. "Dependence structure of risk factors and diversification effects," DNB Working Papers 219, Netherlands Central Bank, Research Department.
    2. Zhang, Dongna & Dai, Xingyu & Xue, Jianhao, 2024. "Incorporating weather information into commodity portfolio optimization," Finance Research Letters, Elsevier, vol. 66(C).
    3. Marco Rocco, 2011. "Extreme value theory for finance: a survey," Questioni di Economia e Finanza (Occasional Papers) 99, Bank of Italy, Economic Research and International Relations Area.
    4. Moore, Kyle & Sun, Pengfei & de Vries, Casper G. & Zhou, Chen, 2013. "The cross-section of tail risks in stock returns," MPRA Paper 45592, University Library of Munich, Germany.
    5. Tavakoli Baghdadabad, Mohammad Reza, 2014. "Average drawdown risk reduction and risk tolerances," Research in Economics, Elsevier, vol. 68(3), pages 264-276.
    6. Zhou, Chen, 2010. "Dependence structure of risk factors and diversification effects," Insurance: Mathematics and Economics, Elsevier, vol. 46(3), pages 531-540, June.
    7. Zhang, Ning & Zhang, Yue & Zong, Zhe, 2023. "Fund ESG performance and downside risk: Evidence from China," International Review of Financial Analysis, Elsevier, vol. 86(C).
    8. Lorne N. Switzer & Jun Wang & Seungho Lee, 2017. "Extreme risk and small investor behavior in developed markets," Journal of Asset Management, Palgrave Macmillan, vol. 18(6), pages 457-475, October.
    9. DiTraglia, Francis J. & Gerlach, Jeffrey R., 2013. "Portfolio selection: An extreme value approach," Journal of Banking & Finance, Elsevier, vol. 37(2), pages 305-323.
    10. Tee, Kai-Hong, 2009. "The effect of downside risk reduction on UK equity portfolios included with Managed Futures Funds," International Review of Financial Analysis, Elsevier, vol. 18(5), pages 303-310, December.
    11. Hwang, Inchang & Xu, Simon & In, Francis, 2018. "Naive versus optimal diversification: Tail risk and performance," European Journal of Operational Research, Elsevier, vol. 265(1), pages 372-388.
    12. Antonio Di Cesare & Philip A. Stork & Casper G. de Vries, 2015. "Risk Measures for Autocorrelated Hedge Fund Returns," Journal of Financial Econometrics, Oxford University Press, vol. 13(4), pages 868-895.
    13. Moore, Kyle & Sun, Pengei & de Vries, Casper G. & Zhou, Chen, 2013. "The drivers of downside equity tail risk," MPRA Paper 45591, University Library of Munich, Germany.
    14. Wang, Qian & Shen, Jianghua & Ngai, Eric W.T., 2023. "Does corporate diversification strategy affect stock price crash risk?," International Journal of Production Economics, Elsevier, vol. 258(C).
    15. Simon Xu & Inchang Hwang & Francis In, 2016. "The Effect of Diversification on Tail Risk: Evidence from US Equity Mutual Fund Portfolios," International Review of Finance, International Review of Finance Ltd., vol. 16(3), pages 483-495, September.
    16. Vitali Alexeev & Francis Tapon, 2014. "The number of stocks in your portfolio should be larger than you think: diversification evidence from five developed markets," Published Paper Series 2014-4, Finance Discipline Group, UTS Business School, University of Technology, Sydney.
    17. Namwon Hyung & Casper G. de Vries, 2010. "The Downside Risk of Heavy Tails induces Low Diversification," Tinbergen Institute Discussion Papers 10-082/2, Tinbergen Institute.
    18. Fang, Yiwei & van Lelyveld, Iman, 2014. "Geographic diversification in banking," Journal of Financial Stability, Elsevier, vol. 15(C), pages 172-181.

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    More about this item

    Keywords

    Diversification; Value-at-Risk; Decomposition;
    All these keywords.

    JEL classification:

    • G0 - Financial Economics - - General
    • G1 - Financial Economics - - General Financial Markets
    • C2 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables

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