Investing: how to reduce concentration risk
Concentration risk. No, it’s nothing to do with thinking too hard about something. In fact, it’s more likely to be a result of not paying enough attention.
Concentration risk is the increase in investment risk that comes about from not sufficiently diversifying your portfolio. In other words, too much money is concentrated in too few assets, sectors or geographical markets.
This can happen:
- Intentionally, because you have a strong belief that a particular share or sector, such as resources, banks or property, is likely to outperform in the future.
- Unintentionally, through asset performance. One or two shares deliver spectacular gains, making the entire portfolio more sensitive to moves in just a couple of assets. Or maybe shares as a whole enjoy a period of strong growth. Even though you hold a large number of different shares, the increased exposure to one asset class increases the risk to your portfolio.
- 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, the art of spreading your money across the main asset classes of shares, property, fixed interest and cash. 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, buying four one-bedroom apartments in the same building, or even in the same area, creates a huge concentration risk.
- Rebalance your portfolio to keep it broadly in line with your ideal asset allocation. This may create a tax liability, but often it’s 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. Even if you are confident in making your own investment decisions it’s wise to run them by a licensed adviser.
It’s surprisingly common for investors to develop an emotional attachment to particular shares or properties they own. Concentration risk can also increase over time due to lack of attention. Your financial planner will assess your portfolio for hidden concentration risk and help you achieve a better balance of investments.