What is Concentration Risk?

One often hears about the investment that went ballistic, and you will find yourself saying, “I knew I should have bought some!”. Now let us consider the opposite case. Got any Bitcoin? The digital currency is down more than 49% Year-to-date. Indeed, it must be an excellent time to buy, right? Not so easy a decision, is it? Hindsight is always 20/20.

You will rightfully argue Bitcoin is not a good example. What if we were to pick six well-known, established companies: General Motors Company, PayPal Holdings Inc, Nike Inc, Netflix Inc, Meta Platforms Inc (Facebook), Zoom Video Communications Inc? Year-to-date, a portfolio composed of these six companies would be down 40.08% (Closed: 29 July). Hopefully, you will now be intrigued to learn more about Concentration Risk.

What is Concentration Risk? If a single asset type accounts for a significant portion of your net worth, that can create a dangerous imbalance for your assets and financial security. Concentration risk is the potential for a given investment to compromise the well-being of a portfolio. Note, when we refer to a “Single Asset”, this refers not only to the underlying asset (i.e. real estate, stocks and bonds, etc.) but also to less apparent risks like geographical concentration where all your assets are invested in one country.

In the case of an investment portfolio, if one company’s stock makes up more than 10% of your investments, it may be too much. The COVID-19 pandemic is the latest example illustrating how a concentrated stock position can swiftly decimate on-paper wealth. Diversifying your holdings typically means reducing your investment risk and locking in gains.

When constructing a healthy portfolio, several types of concentration risk need to be factored in. These include, but are not restricted to:

Legislative: Legal action against a company, fines, or legislative restrictions can impact core operations.

Regulatory: Regulatory shifts may place new restrictions on an industry or impact its operation ability. The pharmaceutical sector remains vulnerable to new regulations restricting its ability to price drugs.

Company risk: Unforeseen risks specific to a company tied to their products/services, competitors, financials, etc.

Industry risk: Industry risk is a type of risk that will affect all participants in the industry through a shared exposure to external factors. The hospitality industry and airline industry have been particularly hard-hit by the pandemic. Another example is the decline of traditional print media and newspapers favouring digital and free content.

Common Biases Associated with Concentration Positions

Though prevalent, a less obvious factor is biases that create concentration risk. As humans, we feel comfortable with what we know.

Recency bias: The tendency to believe that recent trends will continue. For example, the belief is that because Apple stock has performed well since 2008, it will continue to serve well long into the future. This bias exists even with investors who understand that companies face the threat of constant competition and industry disruption that can cause unexpected drops in a stock’s value.

Familiarity bias: Investors are more likely to invest in companies well known to them. For example, if you use Apple’s products, you may be more likely to invest in its stock, regardless of other performance indicators.

Overconfidence: Being too confident in a company can prevent an investor from seeing a situation for what it is.

Confirmation bias: Investors seek information that aligns with their preconceptions and disregard information that does not.

Anchoring bias: is when an investor relies too heavily on a single piece of information, often the first thing they learn about a specific stock or company.

Having Your Eggs in One Basket When Things Go Wrong

Here we have two example portfolios:

When you have a large percentage of your portfolio in one stock, the potential for substantial losses increases dramatically.

When you over allocate a considerable amount of your money into one outcome, the effect of that outcome on your total portfolio is more pronounced.

Does A 40% Fall Seem Excessive?

A 40% fall can seem like it could never happen to well-established names, but as we saw earlier even well-known names too can fall dramatically. Note, that these are big household names with conglomerate revenue structures and strong balance sheets.

It shows how even the big names are fundamentally exposed to these types of returns. Yes, we are cherry-picking the worst of the worst, but it is just an illustration that these downturns are not improbable.

Company Year-to-date performance Return required to recover losses
PayPal Holdings Inc. -55.96% 127%
General Motors Co. -41.57% 71%
Nike -31.85% 47%
Netflix -62.16% 164%
Meta Platforms (Facebook) -52.53% 111%
Zoom -42.35% 73.5%

(All prices are as of 29 July close)

How should I Go About Fixing This?

The most straightforward way is to sell some of your concentrated stock. We might do this over multiple years, and you’ll want to do this in the most tax-efficient manner.

Levantine & Co can work with you to put together a plan to help take the psychology out of selling your stock and create some protection against that downside.

Whether it’s selling across one year or seven years, you’ll want to work on a strategy designed to protect the money you worked so hard to earn from suddenly disappearing.

The Benefits of Diversification

● Preserving Capital

● Minimising risk of loss

● Generating consistent returns

● The chart illustrates the reduction of the portfolio risk as the number of stocks in a portfolio increases.

If you have concerns about your portfolio or would like to learn more about how we manage concentration risk in our portfolios, please feel free to contact us.

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