A diversified portfolio tends to be harder to achieve than simply following the mantra to steer clear of putting all your investment eggs in one basket. This basic strategy can help, but it’s often not enough to avoid concentration risk—the risk of amplified losses that may occur from having a large portion of your holdings in a particular investment, asset class or market segment relative to your overall portfolio.
The first step in managing concentration risk is to understand how it might occur. Concentration can be the result of a number of factors:
- Intentional concentration. You might believe a particular investment or sector will outperform its peers or an index, so you make a conscious decision to invest more of your money in a given asset or asset class.
- Concentration due to asset performance. Maybe one of your investments has performed very well relative to the rest of your portfolio. For instance, in a bull market, you might find that your stock holdings now represent a significantly greater percentage of your portfolio than before since your stocks gained more value than your bond holdings.
- Company stock concentration. Employees might be tempted to concentrate their retirement savings in the stock of their employer.
- Concentration due to correlated assets. Investments within the same industry, geographic region or security type tend to be highly correlated, meaning that what happens to one investment is likely to happen to the others. For instance, you might own a variety of municipal bonds, but all of them are in the same state or region. Or you might have investments in individual technology companies but also own a technology fund and have technology stocks represented in an index fund you own.
- Concentration in illiquid investments. Certain investments such as private placements, unlisted direct participation programs and non-traded real estate investment trusts (REITS) might be difficult to sell quickly. Other investments, including variable annuities, might impose a surrender charge if you try to sell before a certain period of time. If you need quick access to cash and are heavily invested in illiquid securities, you might not be able to tap this money in a timely or cost-efficient manner.
Tips to Manage Concentration Risk
The following tips can help manage concentration risk.
1. Diversify across and within the major asset classes. Do you hold multiple asset classes (such as stocks, bonds and real estate)? Are your stock holdings spread among different sectors (biotech, electronics, retail and emerging markets, to name a few)? Is your bond portfolio diversified by issuer and type of bond (corporate, municipal and Treasury), and do the bonds mature at different intervals? Mutual funds and exchange-traded funds (ETFs) can be helpful in achieving broad diversification, as can life-cycle funds, which have the added bonus of rebalancing automatically as you age.
2. Rebalance regularly. Regardless of whether you manage your own portfolio or have it managed by a financial professional, perform periodic reviews of your holdings, and make adjustments to ensure they coincide with your investment objectives. If you’re saving through an employer-sponsored retirement plan, your plan might offer automatic rebalancing, or rebalancing assistance through the plan administrator.
3. Look "under the hood" of each mutual fund or ETF you own. Read the fund's prospectus or visit the fund's website to see if your funds are holding positions in similar companies or if they overlap with any individual stocks or bonds you may own. Make use of this information as you rebalance, and examine your exposure to individual investments. Also be aware that some funds can be highly targeted to specific investments such as a single commodity, or emerging markets in a specific part of the world. Simply holding only funds doesn’t shield you from concentration risk.
4. Know how easily you can sell your investments. Low-priced stocks, non-traded REITs and private placements might be hard to sell on short notice or at an efficient price. Some bonds, such as mortgage-backed securities, might also be less liquid than other types of bonds. To learn about an investment's liquidity, read the offering documents or ask an investment professional. If a large percentage of your portfolio is tied up in illiquid securities, consult an investment professional about potential remedies.
It's not always easy to tell when your portfolio is exposed to concentration risk. This is especially true of portfolios that contain complex investments. For instance, if you own a reverse convertible note linked to the performance of a specific stock, you might be exposed to concentration risk if you also own the individual stock in a brokerage account. Similarly, you could own a mutual fund where the stock is one of the largest holdings.
If you think your portfolio may suffer from over concentration, talk to a financial professional, and take appropriate action to manage your risk.