R Programming for Actuarial Science

7 Benefits of Diversification

Peter McQuire

library(MASS)

7.1 Introduction

In this chapter we will look at why diversification is one of the key tools in risk management. In particular, we shall look at:

• the importance of holding uncorrelated risks, or at least risks which can be considered not to be highly correlated;
• the effect of increasing the number of risks.

We shall also demonstrate these concepts by simulating returns from various asset portfolios. The chapter does contain less coding than most chapters in the book.

Remark 7.1 When we discuss “risks” in this chapter, we will typically be referring to insurance policies, loans or assets. For example the first bullet point could relate to insurance companies selling uncorrelated insurance policies, or to a pension scheme investing in several uncorrelated assets.

7.2 Background

Diversification is used by most financial institutions as a way of reducing uncertainty in future financial results; banks diversify by writing loans to many different individuals and institutions; insurance companies diversify by writing lots of largely uncorrelated insurance policies. Investment strategies adopted by insurers, occupational pension schemes and other institutions will be heavily influenced by the concept of diversification by investing in several different types of investment opportunities. Companies in general should be aware of the benefits which diversification can bring, for example by trading in various countries, selling ...