Diversification and Stochastic Dominance: When All Eggs Are Better Put in One Basket

TL;DR

This paper challenges the conventional wisdom of diversification by showing that, for heavy-tailed risks with infinite mean, a diversified portfolio can have higher tail risks than a single-risk benchmark, especially in extreme cases.

Contribution

The paper introduces the one-basket theorem, providing new conditions under which diversification increases tail risk for heavy-tailed risks, with applications to Pareto distributions.

Findings

Diversification can increase tail risk for heavy-tailed risks.

The one-basket theorem offers criteria for stochastic dominance in risk portfolios.

Diversification failures are boundary cases of a broader phenomenon.

Abstract

Diversification is usually viewed as a reliable way to reduce risk, yet it can dramatically fail for heavy-tailed losses with infinite mean: pooling independent losses of this type may increase tail risk at every threshold. We study this reversal by comparing a diversified portfolio (a weighted average) of risks to a "one-basket" benchmark that concentrates the full exposure on a single component chosen at random according to the same weights. In the iid case, the benchmark reduces to a single risk, recovering the classical comparison between a single risk and a diversified portfolio. Our main result -- the one-basket theorem -- provides new sufficient conditions under which the diversified portfolio has larger tail probabilities for all thresholds (first-order stochastic dominance) than this benchmark. The theorem enables weight-specific verification of the stochastic dominance relation and yields new applications, notably to averages of infinite-mean discrete Pareto risks. We further show that these failures of diversification are boundary cases of a general phenomenon: diversification always increases the likelihood of exceeding thresholds near zero, and under specific conditions this local effect extends to all thresholds, yielding first-order stochastic dominance.