The risk inherent in proverbially “putting all eggs in one basket.” When people, investment assets, or opinions are clustered, all are simultaneosuly more susceptible to hazards or errors than they are when more dispersed. For example, an army infantry unit clustered closely together is at greater risk from one missile than a dispered unit. An investment portfolio focused on just one type of investment, for example, real estate, is significantly more exposed to certain financial risks such as increased interest rates, than a properly diversified portfolio of investments across various industries, geographies, and security types (stocks, bonds, and real estate holdings). Perfectly synchronized opinions in a committee setting means less diversity and greater likelihood of mistaken conclusions.
Investing all of one’s assets in the stock of gold mining firms.
The price of gold plummets, driving the profits of most gold mining firms down and causing many of them to go out of business. Their stock values go to zero, severely reducing the value of the investment portfolio.
Market conditions lead to a significant spike in the price of gold. Gold mining firms’ stock values leap upward, leading to a huge financial windfall.
Correlation is the statistical measure of the strength of the relationship between two variables. In finance, correlation typically refers to the extent to which the values of any two financial instruments move together. A positive correlation indicates the values generally move in the same direction (both go up or both go down). A negative correlation indicates the values move apart (when one is up, the other is down). Instruments exhibiting low or negative correlation may be used to diversify each other. When contagion occurs, correlations tend to move higher, reducing or completely removing the possibility of diversification.
Contagion is the transmission of adverse events: political, financial, economic, or medical—across borders, financial markets, or among people.