Concentration Risk

By Ben Dolan, CFP®

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My twelve-year-old son (also named Ben) made roughly $400 dollars over the summer doing odd jobs: plant sitting, dog sitting, cat sitting, and even rat sitting! In our house, when the kids earn money, they are required to follow the three S rule of saving, sharing (give to charity), and spending.  

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Once Ben knew how much he was required to share and allowed to spend, he asked me how he should save the balance, given the amount was more money than he had made in previous Summers. Naturally, this sparked a conversation about investing and markets. Ben REALLY liked the idea of his money making money, and asked a pertinent question: “How do I make my money grow as fast as possible in the shortest amount of time?” My response was tongue-in-cheek, given we had not yet talked about risk: “That’s easy, find a small company that nobody knows about and is guaranteed to succeed and invest all your money in their stock.”

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But my retort made me think about the abnormal number of recent conversations I’ve had with individual investors about concentration risk, defined as the potential for dramatic losses in your portfolio due to overexposure to a small number of securities, sectors or regions (these investors are not to be confused with VC firms in the business of taking huge risk with thirty companies and only needing one to hit it big for huge payday).

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Often, these investors are caught off-guard by how they ended up with a concentrated position. Depending on your employer and role withing the company, stock options may be part of your compensation. Inheritance, gifts, divorce, and seed investing can also result in your portfolio having too much of an individual position, or a small number of positions.

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Investors with concentrated positions should always be assessing risk. In short, can they handle the impact of the investment going to zero, which is always a possibility (e.g. Enron, Washing Mutual, the list goes on).  

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Many investors with concentrated positions avoid the issue because they don’t want to pay taxes. This is a classic case of letting the tax tail wag the dog. If your investment has gains, congrats! But you’ll need a plan to exit the position if you’d like to diversify away the risk. Doing so may involve paying some taxes, but perhaps over a few years instead of all at once so that the tax burden is not too cumbersome.  

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Those with stock options often have greater insight into the company than those outside the company, providing them with a level of comfort in their concentrated position. While this may be true, they also have a lot more to lose, given that both their human capital and their financial capital are tied to one company. If the company goes bust, they lose their stock and their job!

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In our opinion, a healthy portfolio will have no more than 10% of assets in a small number of stocks. The remainder of the portfolio should be diversified across multiple industries, regions, and sectors at a very low cost.

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My conversation with Ben ended with a discussion about risk. His preference was to forgo the potential of huge gains and losses for owning thousands and thousands of companies around the world. Smart kid.