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What is overconcentration?

Overconcentration is a type of suitability violation often alleged by investors in claims against brokerage firms in FINRA arbitration.

As a general rule, most investment professionals agree that investors should seek to build diversified portfolios. This follows the old adage, “don’t put all your eggs in one basket.”The logic behind this policy is simple: the more money an investor has invested in one single stock, the more risk he or she faces if that stock fails. If an investor has 50% of his or her entire net worth invested in the stock of ABC Company, for example, the investor could lose 50% of his or her entire net worth if ABC Company declares bankruptcy.

For this reason, most brokerage firms have internal policies or published recommendations that advise brokers not to recommend that any customer hold more than 5% – 10% of their overall portfolio in any single stock or other position, absent unusual circumstances.

Overconcentration violations need not be limited to specific stocks or individual positions. A portfolio can also be over concentrated in a single sector of the economy. As an example, during the technology bubble of the late 1990s many brokers committed suitability violations by recommending that clients build portfolios that were over concentrated in the technology sector. Even though these portfolios had many individual technology stocks, the portfolios were still over concentrated in one sector of the economy – technology.

Many brokers fall victim to recommending whatever stock or sector of the economy is hot at any given time. In doing so, these brokers ignore sound investing principles and may be committing a suitability violation by advising their clients to place too many eggs in a single basket.

Please Note: Rabin Kammerer Johnson provides these FAQs for informational purposes only, and you should not interpret this information as legal advice. If you want advice as to how the law might apply to the specific facts and circumstances of your case, please contact one of our attorneys.

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