By Caleb Sugg
Over-concentration is often a large threat to unsophisticated investors. Simplified, over-concentration consists of putting too many assets into one type of holding and in doing so, risking losing those funds. The following is information to aid the unsophisticated investor in identifying types of over-concentration.
Over-concentration can occur in a portfolio in numerous ways. A portfolio may be over-concentrated in a single fund intentionally. This most often occurs when either the investor, broker, or both believe a particular fund will perform well enough to balance the risk.
Investors may also become intentionally concentrated in their own company’s stock by investing the majority of their retirement into the holdings of their employer.
A portfolio may also become over-concentrated when a particular holding performs very well. For example, a holding in stocks may perform very well, while other holdings under-perform. This creates an account value dominated by holdings in stocks, which, consequently, exposes the majority of the portfolio to the same risk. This type of over-concentration can also occur intentionally. A broker may recommend purchasing more shares from a particular company, which may include opening a margin account to purchase more shares.
The next way a portfolio may become over-concentrated is when funds or stocks are closely related. This scenario is most often seen when stocks or bonds are in the same geographical region and/or the same type of company. Holding securities which are highly correlated can be just as risky.
Finally, illiquid investments can be a cause for concern. A balanced portfolio typically contains a mixture of funds that are not liquid and other funds that can be traded or sold without penalty. The problem occurs when the majority of holdings in a portfolio are concentrated in illiquid holdings. For older investors, forcing funds to be tied down for a number of years can create issues when the investor wishes to liquidate the funds, only to discover there are large penalties or losses involved.
To protect your investments from over-concentration, take into consideration the following tips. First, diversify your accounts—have a portfolio consisting of multiple different types of funds, stocks, and other holdings. This also applies to your company retirement investments. Second, continuously reevaluate and rebalance your portfolio. Third, research specific funds to discover what they invest in. Finally, know whether or not you can sell your holdings. Ask your broker and conduct your own research to determine whether or not your portfolio is over-concentrated.