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What Is Lack of Diversification?

Simms Law, P.C. June 14, 2022

Investors expect their brokers to help them build portfolios that meet their investment objectives.  Diversification, which is the process of investing in a variety of industries, companies, and investment types, is a necessary component of this process. However, lack of diversification, which results in a portfolio that is overly concentrated in one area, creates undue risk for investors and can result in catastrophic investment losses. Below is an overview of how lack of diversification hurts investors.

How Does Lack Of Diversification Create Risk?

A portfolio that is not properly diversified leaves investors vulnerable to market fluctuations and industry downturns. The market is liable to turn at any moment, and a diversified portfolio provides protection against unpredictability. It is not uncommon for specific companies or entire industries to come crashing down, leaving investors with huge losses. Simply put, investors with assets concentrated in one or two specific areas are taking a big risk. As opposed to diversified investors, such individuals will often suffer enormous financial setbacks when things go bad.

Bouncing back from investment losses can be difficult

It can be extremely difficult to bounce back financially after suffering huge losses due to a poorly diversified portfolio. Watching one’s investments plummet can also take a huge emotional toll on investors and their families. Competent brokers understand that diversified portfolios are the best way to protect investors from catastrophic financial loss. Unfortunately, however, not all brokers understand this, ignoring their clients’ wishes and concentrating funds in risky industries and companies.

Can brokers be held liable for lack of diversification?

Brokers and financial advisors are required to comply with rules and guidelines of the Financial Industry Regulatory Authority (FINRA). And when FINRA rule violations result in financial losses, investors may have legal recourse. Under FINRA Rule 2111, brokers and financial advisors must have a reasonable basis for making investment recommendations, and they must ensure that all proposed investment activity is suitable for each specific client. Usually, an investment strategy that results in an investor taking on too much risk is not suitable. And part of complying with the above rule and meeting FINRA’s suitability requirements involves the creation of a properly diversified portfolio. Therefore, when a financial advisor or broker recommends an investment strategy that results in a poorly diversified portfolio, it is important to seek legal guidance, as the affected investor may be able to hold the responsible individual liable for his or her investment losses.

Investor Representation Attorney

At SIMMS LAW, P.A., one of our primary focuses is the representation of investors. The financial markets can result in great gains and losses, so expert legal representation is a must when attempting to navigate this complex area. At SIMMS LAW, we always take our clients’ concerns seriously and are aware of what is at stake when an investor suffers losses in the financial markets. Therefore, if you require expert legal guidance, please contact us for a consultation.