Friday, 31 October 2008

Up or across

I'm stuck on a thought at the moment: was it wrong for the financial industry to believe that diversification reduced risk? Now, it is thought that diversification actually stacked up risks on top of each other, until it all came crashing down. But was diversification a mistake in concept or in practice?


Anonymous said...

Correlations differ at the money and in the tail. In the case of tranched derivative structures on underlying mortgage assets, tranching served to concentrate systematic risk in the senior tranches.

matt h2o said...

Diversfication wasn't the problem, in principle, complexity (and an associated lack of transparency) was. Because the paper was so convoluted, it was easy to get over-exposed to certain risks because people didn't realise that a lot of the paper was essentially self-referential - which made it not diversification, but concentration.

Diversification would still work, you just need more transparency.