Investing: How to Reduce Concentration Risk

reduce-concentration-risk

Concentration risk

No, we’re not talking about thinking too hard about something. In fact, it’s much more likely to be a result of not paying enough attention.

Concentration risk is the increase in investment risk that comes from a lack of sufficient diversification in your portfolio. In other words, too much money is concentrated in too few assets, sectors, or geographical markets.

This can happen:

  • Intentionally, when you have a strong belief that a particular share or sector (such as resources, banks or property) is likely to perform well in the future.
  • Unintentionally, through asset performance. If one or two shares deliver spectacular gains, the entire portfolio can become more sensitive to moves. Or, perhaps, shares as a whole enjoyed a period of strong growth. The increased exposure to one asset class increases the risk to your portfolio, despite holding a large number of different shares.
  • Accidentally, through poor asset selection. As at January 2019, all ten top companies that make up the MSCI World Index also appear on the top ten list of the main US index, the S&P 500. Investing in two funds, one that tracks the world market and one that tracks the US market won’t deliver the level of diversification you might expect.

Managing your risk

The solution to concentration risk is our old friend, diversification.

  • Appreciate the importance of asset allocation. Learn the art of spreading your money across shares, property, fixed interest, and cash (the main asset classes). Ensure your asset allocation matches your tolerance to investment risk.
  • Diversify within each asset class. Holding the big four banks is not a diversified share portfolio. If property is your thing, make sure to spread your purchases around different areas.  Buying multiple one-bedroom apartments in the same building – or even in the same area – creates concentration risk.
  • Rebalance your portfolio to keep it broadly in line with your ideal asset allocation. This may create a tax liability, but it’s often better to pay some tax than to carry too high a level of concentration risk.
  • Understand each investment and its role in your portfolio. Does share fund A hold similar shares as share fund B? Do they both have the same strategy?
  • Get a professional opinion. It’s wise to run your investment decisions by a licensed adviser, even if you’re confident in your choices.

Keep Tabs on Your Portfolio

Surprisingly, it’s common for investors to develop emotional attachments to particular shares or properties they own. Concentration risk can also increase over time due to lack of attention.

Your financial planner can assess your portfolio for hidden concentration risk and help you achieve a better balance of investments. Book a check-in today to make sure your portfolio is performing at its best.

 

This represents general information only. Before making any financial or investment decisions, we recommend you consult a financial planner to take into account your personal investment objectives, financial situation and individual needs.

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