Question

Discuss concentration risk and how portfolio optimization can be adjusted to manage.) concentration risk. What might be the consequence be to the feasible set and changes in the efficient frontier managing concentration risk?

Answer 1

From the perspective of Modern Portfolio Theory, concentration risk refers to the risk that arises from a portfolio that is not adequately diversified such that it may face downside risks from one or few aspects

Examples:  

1. A global portfolio skewed towards one particular country
2. Portfolio diversified across several asset classes concentrated in equity (as an example) or any one particular asset
3. Portfolio heavily concentrated in one or few positively correlated industries

The efficient frontier is the basis for the Modern Portfolio Theory. Various combinations of assets held by an investor represent different levels of risk and return (and thus the risk-adjusted return for such combinations). An efficient portfolio is one for which a certain level of risk, provides the maximum return or for a certain level of required return has the lowest risk. A combination of all such efficient portfolios for different levels of risk and return represent the ‘efficient frontier’. This is know as portfolio optimization.

The efficient frontier lets investors ascertain risk-adjusted returns of all possible portfolio combinations (optimize the portfolio), allowing to seek lower risk for a given level of required return by choosing from a plethora of portfolio combinations, thus increasing diversification (reducing concentration risk).