Concentration risk - Financial definition
Concise definition of the term concentration risk
Concentration risk refers to the potential for significant financial loss arising from an overexposure to a single asset, counterparty, sector, or geographic region. This risk occurs when a lack of diversification makes the portfolio more vulnerable to adverse events affecting the concentrated positions.
Comprehensive definition of the term concentration risk
Concentration risk is a critical aspect of risk management in finance, as it highlights the dangers of insufficient diversification within a portfolio. This type of risk is particularly relevant in the context of large institutional investors, such as banks or hedge funds, where significant exposure to a single borrower, industry, or region can lead to substantial losses if adverse conditions occur.
Practical examples include a bank heavily invested in the real estate sector facing significant losses during a housing market crash or an investment portfolio with substantial holdings in a single technology company experiencing sharp declines due to poor earnings reports. Market practices to mitigate concentration risk include implementing diversification strategies, setting exposure limits, and regularly monitoring and rebalancing portfolios to ensure no single exposure becomes excessively dominant.