How Homogeneous Diversification in Balanced Investment Funds Affects Portfolio and Systemic Risk

The recent financial crisis highlighted the dangers of systemic risk. In this regard no common view appears to exist on the definition, measurement, and real impact of systemic risk on the financial system. This paper aims to analyze the relationship between systemic risk and portfolio diversification, highlighting the differences between heterogeneous and homogeneous diversification. Diversification is generally accepted to be the main tool for reducing idiosyncratic or portfolio-specific financial risk, however homogeneous diversification also has implications for systemic risk. Using balanced investment funds data, the empirical analysis first investigates how diversification affects the two components of individual portfolio risk, namely systematic, and idiosyncratic risk, and then uses an estimation procedure to examine the change in asset allocation and its impact on global systemic risk. The results suggest that funds' portfolio diversification reduces at the same time the portfolio-specific risk and increasing the likelihood of a simultaneous collapse of financial institutions - given that a systemic event occurs.