Network origins of portfolio risk

This paper shows that shocks, in the presence of asymmetric propagation structures, diminish investors’ diversification benefits. First, we construct an interdependency network with assets as nodes, and links corresponding to cross-dependency in returns. Second, we show that higher heterogeneity in the structure of the network increases portfolio risk. In particular, diversification among assets with star-like network structures, where a central asset cross-affects other assets in the portfolio, results in the lowest level of diversification benefits. Finally, we empirically demonstrate that two distinct datasets of U.S. industries and international stock markets greatly resemble star-like network structures.