Most investors understand that there are different types of risk in an equity portfolio. The most severe, default risk, is that a company will go bankrupt and the value of the equity will fall to zero. A less extreme risk, market risk, is that a stock’s price fluctuations will become unacceptably wide.
These risks are interrelated in any portfolio. When a stock is in danger of default, its market risk may also increase, and this may affect the volatility of other holdings.
Investors might think that the best solution would be to sell the stock with both default and market risk, and split the remaining capital between a safe money market account and an investment that is not in danger of default.
A better strategy might actually be the complete opposite, according to research by Chicago Booth’s John R. Birge, University of Science and Technology of China’s Lijun Bo, and Columbia’s Agostino Capponi.
The researchers propose that in this case the best approach would be to allocate money to the investment that will reduce overall risk to the portfolio the most. In all but the most extreme cases, this means continuing to allocate capital to the riskier investment—because a small improvement in the conditions for the riskier investment will have the largest effect on reducing risk in the portfolio overall, and the premiums earned from the risky investments will have the effect of maximizing returns.