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A Brief Note On Risk Management Through Traditional Diversification

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2.1 Inefficiency of risk management through traditional diversification
Risk is a probabilitic value. The notion of risk is considered as probability of happening of adverse events, and the risk can not be completely eliminated. The risk can be only reduced. In financial management elimination of the risk is meant as its maximum reduction (minimization). The portfolio, which neutralized the risk caused by a particular event, called for a balanced portfolio against the risk.
The main methods of reducing the risks associated with investments in securities based on portfolio formation are:
1) diversification of risks;
2) hedging of risks (as a special case diversification);
3) the transfer of losses to another person by means of guarantees …show more content…

However, asset class correlations are less stable than many investors realize, and longterm trends such as globalization are driving correlations higher. In addition, correlations typically increase during periods of market turbulence. As a result, seemingly distinct asset classes are likely to behave more similarly than many people expect.
In other words, even portfolios that are well diversified across asset classes may not be positioned to adequately diversify and cushion market volatility (Figure 2.1). Asset class diversification is not the same as risk diversification. In the chart, a portfolio is broadly diversified across asset classes, but in fact has a very concentrated exposure to underlying equity risk. Understanding these risk factors is key to creating an efficient, risk-managed allocation strategy. Figure 2.1 Asset class exposure Traditional portfolio construction approaches, which focus on asset class diversification, may fall short of investors’ goals. A more efficient diversification strategy may be to allocate across the underlying “risk factors.”
Risk factors are the underlying risk exposures that drive the return of an asset class (see Figure 2.2).

Figure 2.2 Risk factor exposure

For example, a stock 's return can be broken down into equity market risk – movement within

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