Systemic Risk Driven Portfolio Selection

We consider an investor whose objective is to trade off tail risk and expected growth of the investment. We measure tail risk through portfolio's expected losses conditioned on the occurrence of a systemic event: financial market loss being exactly at, or at least at, its VaR level and investor's portfolio losses being above their CoVaR level. We obtain a closed-form solution to the investment problem, and decompose it in terms of the Markowitz mean--variance portfolio and an adjustment for systemic risk. We show that VaR and CoVaR confidence levels control, respectively, the relative sensitivity of the investor's objective function to portfolio--market correlation and portfolio variance. Our empirical analysis demonstrates that the investor attains higher risk-adjusted returns, compared to well known benchmark portfolio criteria, during times of market downturn. Portfolios that perform best in adverse market conditions are less diversified and concentrate on few stocks which have low correlation with the market