Inter-Sectoral Linkages and Risk Diversification in the Kuala Lumpur Stock Exchange

Abstract

‘This empirical study shows that risk reduction through sectoral portfolio diversification is not effective in the long run as the major sectors of the KLSE appear to share a common stochastic trend in the long run, meaning that they tend to move together in the long run. The reduction of risk, however, seems to be possible in the short run, as non-systematic shocks generated in one sector might not be propagated simultaneously to another sector when there is no direct causal effect from the shocked sector to the other. Even though these sectors might be causally linked indirectly through a third sector, this kind of indirect link usually exhibits some lags in time, and thus allows investors, who monitor trading closely with rational expectation, to make quick adjustments. Among the various sectors in the KLSE, the Industrial Products, Finance and Property are the three leading sectors that exhibit direct causal effect on many other sectors.