Stocks and your portfolio: Keep an eye on concentration risk

When investing in the stock market, a diversified portfolio tends to be harder to achieve than simply following the mantra: don’t put all your investment eggs in one basket. This basic strategy can help but it is 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 investors who build large positions in a company stock may not be paying attention to the concentration level in their portfolios or they could simply be ignoring the risk, possibly because they are overly optimistic about their company’s future. 

Concentrate on concentration risk

‘The reluctance to diversify’ the still-developing field of behavioural finance provides a lens into some of the most common impediments to selling a concentrated stock position and diversifying the portfolio: emotional ties to the stock and cognitive biases. The stock has likely made the investor wealthy, typically because he/she, a family member or an ancestor grew the company, giving the investor a strong emotional connection to the investment.

Perhaps the stock was inherited from a beloved family member or perhaps the family’s name is attached to the company. In addition to the emotional ties, some of the most common factors that lead investors to hold on to concentrated positions are as follows:

Anchoring and reference dependency. Investors tend to anchor to an arbitrary or inappropriate reference point. For example, an investor may say: “I will not sell Company A until the stock price hits Rs.100” or “I will not sell until the price gets back to Rs.100.”

Overconfidence. Confidence implies a realistic level of trust in one’s abilities, while overconfidence implies an overly optimistic assessment of one’s knowledge or control over a situation. Concentrated stock investors may have deep knowledge about the company, which may give them confidence in the company’s longevity and ability to succeed. Diversifying into unknown stocks, however, means buying companies in which an investor is not as familiar or confident.

Regret avoidance. Watching a stock rise can generate regret on the part of those who have sold the stock; fear of this regret can discourage investors from taking action.

Intentional concentration. You may 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 may find your stock holdings now represent a significantly greater percentage of your portfolio. 

Company stock concentration. Employees may be tempted to concentrate their retirement savings in the stock of their employer. 

Selling a concentrated stock position is difficult and often involves complex emotional issues for most investors. However, holding a concentrated stock can imperil wealth preservation.

Why are concentrated stock portfolios risky?

One single stock is generally much more volatile than a diversified portfolio of stocks because in a portfolio the negative stock-specific events of one stock may be offset by the positive stock-specific events of other stocks. Further on, investors concentrating in one stock run a greater risk of a sharp decline in the value of their portfolios than investors who diversify.

Tips to manage concentration risk

The following tips can help manage concentration risk.

1. 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 it coincides with your investment objective. 

2. Know how easily you can sell your investments. 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.

3. Long/short funds 

A long/short equity strategy holds both long and short equity positions. If the investment manager believes a company’s share price will appreciate, it can go long and buy shares in that company. Conversely, if the manager believes a company is overpriced or unlikely to prosper due to structural, economic or company-specific factors, they can go short and sell its shares.

A long short equity strategy seeks to profit from share prices appreciation above the index in its long positions and price declines below the index in its short positions.
There are two primary benefits from employing a long/short strategy:

The investment manager can tap into underperformance of the market by identifying losers as well as winners. Traditional managers leave that information on the table as they can’t do anything with it. A long/short fund unlocks that potential and gets extra returns out of the ‘losers’.

Increased diversification – Many Sri Lankans are often forced to take concentrated positions. Rather, the combination of long and short positions potentially enables greater diversification, which may help to mitigate risk, particularly in a volatile market.

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. 

If you think your portfolio may suffer from over concentration, talk to a financial professional and take appropriate action to manage your risk. Concentration risk is real. The sooner you give your portfolio a concentration check-up the better.