This paper studies the extent to which basic principles of portfolio divers
ification explain "contagious selling" of financial assets when there are p
urely local shocks (e.g., a financial crisis in one country). The paper dem
onstrates that elementary portfolio theory offers key insights into "contag
ion." Most important portfolio diversification and leverage are sufficient
to explain why an investor will find it optimal to significantly reduce all
risky asset positions when an adverse shock impacts just one asset. This r
esult does not depend on margin calls: it applies to portfolios and institu
tions that rely on borrowed funds. The paper also shows that Value-at-Risk
portfolio management rules do not have significantly different consequences
for portfolio rebalancing than a variety of other rules. [JEL F36, G11, G1
5].