All Eggs, One Basket: When Diversification Backfires in Risk Modeling
TL;DR for operators Diversification is not wrong. That would be too easy, and therefore suspicious. The sharper point in Léonard Vincent’s paper is that diversification can fail in a very specific, very strong way when losses are extremely heavy-tailed and may have infinite mean.1 The paper compares two portfolios built from the same risks and the same weights. One spreads exposure across all risks as a weighted average. The other puts the whole exposure into exactly one randomly selected risk, using the same weights as selection probabilities. Under the paper’s conditions, the diversified portfolio has higher exceedance probability at every threshold. ...