What is concentration risk, and why can a portfolio look diversified on paper yet be dangerously concentrated?
A core Risk & Compliance interview question — asked in analyst and associate interviews across IB, PE, and the Big 4.
THE SHORT ANSWER
Concentration risk is the danger from excessive exposure to a single counterparty, sector, geography, product, or risk factor, such that one event causes outsized loss. A portfolio can look diversified by counting many names or positions yet be concentrated because the exposures share a common driver — e.g., many different borrowers all dependent on oil prices, or many mortgages all exposed to one regional housing market, or many counterparties all sensitive to the same interest-rate move. Correlation, not just the number of names, determines true diversification; in stress, correlations rise and seemingly independent exposures move together. You manage it with single-name and sector/geography limits, look-through to underlying risk factors, correlation-aware measures (and stress/reverse-stress tests that hit common drivers), and economic-capital add-ons for concentration that standardized capital formulas (which often assume an infinitely granular portfolio) miss. The lesson is to measure exposure to underlying drivers, not just count positions.
WHAT INTERVIEWERS LISTEN FOR
- ✓Excessive exposure to one name/sector/geography/risk factor
- ✓Diversification depends on correlation, not the number of names
- ✓Common drivers (and rising stress correlations) defeat apparent diversification
- ✓Manage via limits, look-through, stress tests, concentration capital add-ons
COMMON MISTAKES
- ✗Equating many positions with diversification
- ✗Ignoring shared risk drivers/correlation
- ✗Relying on granularity-assuming standard formulas
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