At the latest when markets began tumbling, financial dependencies became a global issue and whole countries’ economies ran the risk of falling apart, the curent crisis gave reason for questioning current investment strategies and even whole economic systems. Beside the banking sector which had to suffer a tremendous loss of trust also insurance companies were mainly affected by the crisis. Considering the credit crisis’ impact on global economy the central research question elaborates on the extent to what diversification of asset investments is a solid risk managing strategy.
To determine the character of this strategy a closer view on the relative importance of diversification in the field of risk management has been taken. Besides diversification of asset investments the assessment criteria will be based on two other highly relevant concepts of risk management namely the consideration of non–linear dependencies during extreme events and handling liquidity risk.
Because investment models of pension funds follow generally a similar pattern than these of insurance companies, an in-depth view on Denmark’s ATP Pension fund’s investment structure has been taken as an example for a successfully implemented investment strategy. The three mentioned sources will be used for section II, which will build up a theoretical framework around the issue being raised in the central research question. In section III, after assessing all three criteria of evaluation they should be used as a measurement for the role of diversification in the field of risk management.
On the extent diversification in asset investments plays a role in the context of other risk managing strategies an evaluation will be made on in Section IV. Section V will contain the conclusion concerning the central research question. Before answering the research question there are three elements that should be made clear; first of all the relation between investing in assets and the involved risk. Secondly, this section contains an introduction of what risk management is about.
And finally it will be described what role diversification plays in the field of risk management. According to Pyndick & Rubinfeld, situations of investment decisions always involve tradeoffs between the monetary gain that could be expected and the riskiness of that gain (2009, p. 159). By nature, especially insurance companies and pension funds tend to spread their asset investments in a much more conservative way than for example banks did in the past.
This behavior can be called risk averse and was in the case of Denmark’s ATP pension fund for the first time effectively developed after the financial crisis in 2001 (Rohde & Dengsoe, 2010, p. 22). Information regarding this particular fund was extracted from Rohde & Dengsoe’s article, which revealed instructive details necessary for a exemplary development of applied risk management. According to that, the creation of guidelines for risk tolerances of funds should ensure a strategy of long-term investment at a low risk level (Rohde & Dengsoe, 2010, p.
23). Two main goals were to be pursued. On one hand ATP’s reserves should be protected against extreme market fluctuations, and on the other hand returns should be created in order to cover the purchasing power of pensions (Rohde & Dengsoe, 2010, p. 24). Therefore, ATP divided its investment assets into two different independent portfolios. By allocating their resources to a variety of activities, Denmark’s ATP fund managers did nothing else than reducing their risk through diversification.
In being more specific regarding the central research question, asset investments can also be themselves diversificated in a similar way in order to spread the risk of return. An investment portfolio is supposed to be consistent out of a variety of more or less single independent assets, that provide a flow of money to its owner (Pindyck & Rubinfeld, 2009, p. 177). The potential risk and expected return of each of the portfolio’s assets should be well balanced in order to guarantee a positive outcome of the pursued investment strategy.
During the recent crisis a majority of investors probably underestimated the uncertainity regarding particular asset classes, that sensitively reacted to extreme events in other asset classes (Eling & Schmeiser, 2010, p. 18). That example just underlines the importance of the question about the role of diversification among the other investment strategies. The third source about Insurance and the Credit Crisis from Eling & Schmeiser describes ten consequences for risk management to be uprised during the recent dept crisis.
That source was essential for the research because it revealed insights into the scope of risk management strategies, of which diversification of assets the research will be focused on. In order to create a suitable measurement of the extent to which diversification of assets is a solid risk managing strategy it will be useful to draw the attention on the riskyness of liquidity deficiency and the transparency of non-linear dependencies during extreme events, which are two other aspects risk management should be concerned of beside diversification.
As far as the solidness of diversification is to be mentioned as the main criterion the two other factors are not less important. In this section standards for the mentioned criteria will be determined as being respectively solid, risk averse, and transparent enough in order to contribute to a successfully implemented investment strategy for insurance companies or similiarily pension funds. Diversification of assets should be seen as a solid risk management strategy as long as it creates diminishing risk for the whole basket of investments.
But because it is proven that full diversification is always inefficient (Wagner, 2010, p.375) and non-diversification is known to be risky, there is a method to calculate an optimal degree of diversification for each individual case, so that its solidness as investment strategy is guaranteed.
That is because overdifersification increase the risk of systemic crises, which are extreme costly for the whole society (Wagner, 2010, p. 375), and underdiversification increase the risk of individual crises for investors or banks. As the recently evolving financial crisis unveiled, the danger of liquidity deficiency has been a threat not only to the banking sector, but to every investing institution including insurance companies.
Therefore risk management should aim to structure investments in a form that liabilities and assets are balanced eventhough unexpectable losses incur. In any other case investments can be called risky regarding the liquidity deficiency of the investing institution. There are no specific regulatory benchmarks, but Value-at-Risk models are being used in order to forecast the maximum losses in worst case scenarios firms need to writedown on their asset investments at a certain time span and confidence level (Lehmann & Hofmann, 2010, p.69).
This maximum accepted loss should be the minimum standard allowance that will be called risk averse throughout further sections of the paper. Non-linear dependencies of asset investments clearly contributed to the dimension of the recent dept crisis or any other extreme event in history. Seemingly independent business sectors, markets, economies, and entire financial systems have been taken influence on each other in a sort of unforeseeably raised chain reaction.
Nevertheless, taking severe losses in nearly all investment sectors into account there have always been investors limiting these successfully. By taking Denmark’s ATP Pension Fund as a positive example, successful risk management is able to create a transparency regarding non-linear dependencies of asset investments. As long as the unexpectable losses during extreme events are adequately compensatory throughout the whole basket of asset investments, that strategy should be seen as making non-linear dependencies transparent enough in order to contribute positively to the risk managing strategy as a whole.
In this section arguments for and against the previously assessed criteria will be figured out, and an evaluation will be made on the extent to which diversifying asset investments can be seen as a solid risk managing strategy when compared to limiting risk of liquidity deficiency and locating non-linear dependencies during extreme events. The most basic assumption for spreading risk is to hold different independent assets in the portfolio, hence to diversify (Pindyck & Rubinfeld, 2009, p. 161).
Thus, if additionally the optimal degree is reached diversification of assets must be seen as a solid managing strategy to its highest extent. Diversification must be, as already stated, a solid risk management strategy. That is only guaranteed as long its degree is pendeng around the optimum level figured out by Wagner (2010, p. 385). Nevertheless, according to Wagner, diversification can also be costly because of an increasing probability of simultaneous failure, which makes a large degree of diversification undesireable (2010, p. 385).
Probably, the particular situation of overdiversification can be found again in the recent dept crisis, which could give reason to contemplate the solidness of diversification. Banks and also insurance companies highly diversified were finally all spreading their risk in the same sectors like mortgage lending and other business models promising exraordinary returns. Because policy-holders of insurance companies have very little incentives to unexpectedely withdraw their money and the differences in the funding model compared to banks, insurers nearly have no risk of liquidity deficiency (Lehmann & Hofmann, 2010, p.65).
A payout model of an insurance company preconditions a preceding event like a fire, flooding, or car accident. And life-insurance policy holders are unlikely to withdraw their money in beforehand because of losses they would be imposed with. This is probably the reason why the financial crisis primarily affected insurance firms less than banks. On the other hand, likewise in the years following the crisis in 2001, insurers themselves were investing in risky business models, and for that reason they were running high risk of liquidity deficiency.
When trying to reobtain their liquidity, by selling assets formerly mainly invested in equity securities during an already declining stock market, insurers had to take severe writedowns on their portfolios into consideration (Lehmann & Hofmann, 2010, p. 66). Considering the adopted definition for riskyness of liquidity deficiency standardized by the benchmark of Value-at-Risk models, appropriate modelling and the transparency of non-linear dependencies is a concern.
Models are often based on linear correlation, which is beyond the scope of incurring extreme events and emphasizes the relevance of non-linear dependencies (Eling & Schmeiser, 2010, p. 15). Without taking this element into consideration risk management is condemned to fail on its objectives. However, it might be arguable if it is possible at all to make non-linear dependencies during extreme events transparent. In case of the recent financial crisis there is not really any empirical data towards the core trigger traceable that could be analysed. Neither is there for the last comparable recession 80 years ago.
Taking all the arguments for and against the single criteria into account, risk management strategies need to fulfill all the mentioned factors in order to be solid. For example, diversification without the recognition of risk towards liquidity deficiency and vise versa can never create on itself a solid investment. Diversification of assets cannot be a solid strategy of risk management by its own. All three criteria as well as all three risk management strategies are interconnected to an high extent. Diversification of assets surely is the basic strategy for risk management, since both of the other cannot fulfil their objectives without it.
But only by effectively implying diversification on its optimal degree, by simultaneously reducing the risk of liquidity deficiency to its minimum, and by being prepared to compensate potential losses through non-linear dependencies during extreme events at all time, diversification is a solid risk managing strategy in order to fulfil an entities investment objective. While the recent crisis gave reason for questioning current investment strategies, the central research question to be answered is to what extent diversification of asset investments is a solid risk managing strategy.
So far it can be stated that in determining an optimum in the extent of using diversification as a risk managing tool the issue of unstable investment practices could be solved. Where exactly this optimum can be found goes beyond the scope of this research, but in order to answer the research question properly it will be assumed that diversification as a investment strategy will be used at a degree that comes very close to that optimum. Elaborative research on the topic reveiled three mainly relevant factors important to the extent diversification of asset investments is a solid risk managing strategy.
Firstly, enhanced solidness of diversification can be reached by using this strategy at its optimum degree. Secondly, fulfilling minimum standard allowances for liquidity deficiency warrants the sustainability of risk management strategies including diversification. Thirdly, the ability of creating a transparency regarding non-linear dependencies of asset investments is crucial in order to diversify at a solid level. As proven by Wagner, non-diversification as well as full diversification are substantially contra productive towards a solid risk spreading investment strategy.
Furthermore an investment strategy can only be solid as long the investors adherence for liquidity defiency backups meet the criterion’s standard eventhough that risk for insurance companies might be lower than in other business sectors ( Lehmann & Hofmann, 2010, p. 65). It can be concluded that the extent to what diversification of assets is a solid investment strategy strongly depends on the mentioned factors and varies at each individual investment basked.
Only if the mentioned criteria meet the set standard expectations, diversification of asset investments can be the most crucial strategy in order to spread investment risk.
Bibliography Eling, M. , & Schmeiser, H. (2010). Insurance and the Credit Crisis: Impact and Ten Consequences for Risk Management and Supervision. The Geneva Papers, 35, 9-34. Lehmann, A. P. , & Hofmann, D. M. (2010). Lessons Learned from the Financial Crisis for Risk Management: Contrasting Developments in Insurance and Banking.
The Geneva Papers, 35, 9-34. Pindyck, R. S. , & Rubinfeld, D. L. (2009). Microeconomics. New Jersey, NJ: Pearson Prentice Hall. 159-191. Rohde, L. , & Dengsoe, C. (2010). Higher Pensions and Less Risk: Innovation at Denmark’s ATP Pension Plan. Rotman International Journal of Pension Management, 3(2),22-30. Wagner, W. (2010). Diversification at financial institutions and systemic crisis. Journal of Financial Intermediation, 19, 373-386.