In the context of investing -- and specifically retail or family office investing -- portfolio concentration risk is the risk that you are overly exposed to something. That something can be any of the following and more:
Inappropriate portfolio concentrations are those that expose your portfolio to more risk than you would like or more risk than would be prudent. As such, assessing the concentration levels within your investment portfolio and taking steps to ensure that they are in line with your goals is a smart thing that should be done every so often.
The good thing is that it’s pretty easy and straightforward to determine the concentration levels for a lot of things like stocks, sectors, and countries (things like determining the concentration to strategies and assumptions is a bit more complex).
Step 1: Compile your entire investment portfolio
This might be the most difficult part as modern investors often have portfolios spread out amongst different account or different institutions. For example, you might have a brokerage account, a savings account for an emergency fund, some random savings accounts, and a 401k plan at work – this isn’t unreasonably complex but it does mean you’ll need to do a bit of work compiling things initially.
In fact – you should have done this already; the info should already be complied! If you’re investing and you don’t have a single source that is updated at least occasionally where you can get a high-level picture of your portfolio, you’re making a mistake. Spending some time on this will be beneficial in many ways, beyond just understanding concentrations and concentration risk.
Step 2: Pick a concentration category (eg. stocks, countries, sectors, etc.)
Next, pick a category against which you'd like to determine concentration levels in your portfolio. Don't start with complex things - start with basic things and move towards more complexity as you slowly get a better understanding of the risk nature of your portfolio.
For example, a great place to start would be sectors - you don't want to be exposed to a particular sector too much. If you're only in tech stocks or only in blue chips, you might want to diversify at bit more, depending on your risk tolerance and investing horizon. At the very least you'll want to know that you're heavily concentrated in particular sectors.
Other key concentrations are for individual stocks (eg. the investor who's absurdly exposed to one particular stock they love at the detriment to proper portfolio risk management and diversification).
Step 3: Simply make a list
For a retail investor doing simple portfolio concentration risk analysis, once you have your portfolio in one place and once you decide what you want to examine, it's very simple to proceed.
All you need to do is make a list with two columns - the particular investment product in the right column and the percent of the portfolio that the investment product represents. This is best illustrated by the table below.
As you can clearly see, this isn't a healthy portfolio. The vast majority of the portfolio is concentrated on
The portfolio has home country bias and seems to biased toward popular or newsworthy tech stocks and friend/family tips. Only 30% (broad market ETF + global ETF) of the portfolio is in a broad, well-diversified, investment product while 55% of the portfolio is in just 3 stocks. That's simply absurd for most investors - unless you're an excellent/skilled investor with a very long time horizon and a high risk tolerance, that sort of exposure is unacceptable.
Step 4: Take prudent risk-mitigating steps to reduce the concentration risk within your portfolio
Finally, after the analysis, you would take action - you'd act in ways to adjust your portfolio to reduce concentration risk. Of course, in doing this you'd want to be prudently confident in the insights on which you base your decisions and you'll want to take other factors into account - these other factors might include tax implications and macroeconomic assumptions.
In our example above, a prudent investor would sell off some of the tech stock exposure and re-assess weather the family member's energy stock tip was actually a good tip (eg. is the stock worth owning). Then, the investor might take the proceeds from these sales and invest them into more well-diversified products like ETFs, focusing both on foreign and domestic ETFs. The investor would also want to make sure to focus on both small cap and large cap ETFs, keeping in mind their risk tolerance and adjusting appropriately.
Finally, the investor might see that they are only in equities - this might make sense but putting some money in bonds or alternatives might make sense for some investors. These decisions are all individual - one needs to act prudently based on their own circumstances.
Concentration risk is only one type of investment portfolio risk, but it's an easy one to spot and fix. A lot of investors are prone to taking on too much concentration risk. They don't do it intentionally - they just lack an investing plan or approach and instead buy stocks here and there based on emotions. This is hard to remedy - not everyone is going to create an investing approach and monitor it over time. But, people easily -- and enjoyably -- do the above exercise once in a while (at least once a year) to see if their portfolio is too concentrated on one stock, one sector, or one economy.
One of the best ways to calm your anxieties during market turmoil is to track your portfolio over time in a robust and sustainable way. What does that look like? It means periodically and consistently -- on a weekly or monthly basis (daily is too volatile and yearly is too high level to see intra-year fluctuations) – in a way that makes you actually have to engage with your portfolio.
This means using software or an app to track might not be sufficient if the app does all of the work for you. One of the best ways to do it is to use an Excel file and simply list your total portfolio value over time, row by row, with each row representing a particular point in time (see example below).
What this will give you is something incredible – it’ll give you some perspective. Perspective is an amazing gift, but it isn’t very easy to come by. To get real perspective, there aren’t a lot of shortcuts you can take – it takes time. But, even if you have been investing for years and years, you still likely won’t gain perspective if you don’t track your portfolio but instead mindlessly go about checking it every once in a while without putting its current value in appropriate historical context. Remember - perspective is earned.
By having some perspective, you'll be less likely to make dumb investing mistakes. When stocks go down severely due to short term market turmoil, you'll have enough historical perspective to understand that markets are volatile in the short term.
This is useful for all sorts of investors - those that invest in stocks obviously, but it's also useful for investors in real estate, derivatives, cryptoassets, and even fixed income (although fixed income can be a bit more complex because it is exposed to interest rate risk in addition to market risk).
Bitcoin and Crypto: Similar to precious metals and commodities, they may add diversification to your portfolio but aren't good standalone investing strategies
If you're here, then you probably already know something about the digital currency called Bitcoin, which has grown in popularity over the last few years. Therefore, we won't discuss what they are, how cryptocurrencies like Bitcoin are obtained, or how they are mined. We will be attempting to answer a simple question: Should you invest in Bitcoin?
More precisely, the problem should be: Should you PURCHASE Bitcoin? This is because Bitcoins can be either purchased or obtained through mining. I won't be discussing Bitcoin mining here because I have only done minimal research on the topic, and your success depends greatly on how you approach the endeavor.
So, should you buy some Bitcoin? Should you spend your US Dollars (or whatever form of currency you use) to purchase this new and unregulated digital currency?
Currency is generally not a good investment for most investors, and Bitcoin and other cryptos are sort of like currencies
For the vast majority of investors, investing in currency or currency trading is a fool's game. There is a lot of risk and uncertainty, and there are always people who are playing the same game but are more informed than you. What makes you think that you will be better able to predict the movements of the Yen or the Euro than another currency trader with more education, a faster computer, and better software? That's what you have to do to succeed in currency trading because the only way you make money in currency trading is when you make the right "bet." Bitcoin is just another type of currency. It's not government-issued or government-regulated, but it is a currency nonetheless. The same principle of currency investing that applies to the plethora of government-issued and government-backed currencies apply to this new digital currency called Bitcoin.
I did say you were making a "bet" when currency trading. You might say, "don't you make a bet on any investment, be it a stock, a bond, real estate, etc.?" The answer to that question is a resounding yes. However, when you purchase some investments, it's a different type of bet you're making.
As we discussed in our article on investing in precious metals like silver and gold, if your gold coin goes up in value it only goes up because of the forces of supply and demand. If my share of Tesla Motors goes up in value, it may be for the same reasons of supply and demand, but it also might be because the underlying value of the company increased. That's an important difference.
It's the same thing with currency. If the value of the Euro goes up, it's only because of the forces of supply and demand. Maybe more people want to hold Euros (eg. interest rates in the Eurozone increase) or the supply of Euros decreases (eg. The ECB decides to print fewer Euros). There can be many other events and factors that affect the supply of and demand for Euros. Either way, there is no underlying value to Euros besides the paper they are printed on. They are worth what we say they are worth. This is profoundly different than the underlying value of a company like General Electric, which makes all kinds of things that people want to buy. If you own a share of General Electric, you own a share of all of its business and you own a share of an income-generating organization.
Getting back to the main point of this subsection, currency trading is just like making a bet on what the future value of a currency will be. If you buy Bitcoins with US Dollars you hope that sometime in the future the Bitcoins will be worth more than they are today. You hope that your Bitcoins will be able to buy more dollars than a number of dollars you used to buy the Bitcoins.
Note: We're ignoring inflation above for simplicity purposes, but you'd want to consider inflation in any such discussion, crypto-related or otherwise
Bitcoin and other cryptos don't generate income
This was briefly addressed above. Bitcoins are just a "thing." You hope that "thing" will be will be worth more in the future. That's the nature of your Bitcoin investment.
I would contrast this with the nature of many other types of investments. If you purchase stocks, you are hoping that the underlying value of the company (based on many factors) improves. If you purchase bonds, you are effectively making a loan to a government or a company and you are hoping that you are repaid an amount greater than your original investment adjusted for inflation. If you purchase real estate, you are hoping that the price of your real estate goes up. That real estate price is dependent on supply and demand for real estate in the community, but it's also dependent on the rental income your real estate can generate and the improvements you make to the property. In the above three examples, the investments are tied to some kind of cash flow: corporate profits or dividends, interest payments, or rent payments.
With investments in currency, there is no income and there is no cash flow. You will sit with that currency until you are ready to sell.That's why investors who aren't overly cocky about their abilities and who have a medium-term or long-term approach prefer to invest in equities, bonds, and real estate rather than currency. Bitcoins are just another type of currency and they have all of the same drawbacks when it comes to investing that any traditional government-issued or government-backed currency would have.
Bitcoin and other non-currency-backed cryptos will add serious uncertainty (in the form of volatility) to your portfolio
The final reason why you should be very cautious in deciding whether to purchase Bitcoin is that there is a lot of uncertainty and most Bitcoin purchasers seem to have less information about what they are purchasing than a traditional investor in equities would have.
Before you purchase a stock you research the company. You look at their financials and their management. If you are a smart investor you look at the actual company itself. You might walk into a store, look at their product, and really think about what this company makes. You then make a decision based on this information about whether investing is a worthwhile risk.
With Bitcoin, you are investing in a digital currency. There's not store to walk into. You know that the supply is increasing (for now) and that the difficulty of creating new Bitcoin (mining) is correlated with the number of people attempting to create them (attempting to mine for them). You know that you need relatively powerful computers to mine Bitcoin. You hear the news stories about people making money by purchasing or mining Bitcoin. But, how much do people really know? To me, it seems like many people are engaging in classic speculation.
There's no way to know whether Bitcoin will collapse tomorrow or whether it will increase in value by ten thousand times. There's even no way to know if people will accept it in the stores you shop at. There's no way to know what the government will say about Bitcoin. There's no way to know if a competing digital currency that is better in every way will come out tomorrow and Bitcoin will become completely worthless.
Even though it's risky, adding Bitcoin and other cryptos to your portfolio might have a benefit or two
Bitcoin might become something you might want to purchase in the future, even if just for using it as a means of exchange. Bitcoin might or might not last, but it's likely that some kind of virtual currency (be it Bitcoin or another virtual currency that does or doesn't exist yet) will become widely used. Throughout history, currencies change and there's no guarantee that the US Dollar (or any other currency that's widely used) will remain popular. It might just be the case that virtual currency will be attractive and used as a possible means of exchange. It might just be that virtual currency will be like money in the future.
Therefore, we can't completely say that you should never hold Bitcoin or virtual currency. However, if we do hold it, we should hold it because it is a useful and efficient means of exchange, not because we are deluded enough to think that holding currency in general or virtual currency specifically is a wise investment compared to the plethora of other investment options available to investors novice or expert.
Gold, Silver, and Other Precious Metals: Use them for diversification and portfolio risk management, but not for long-term investing
Gold and silver might be good ways to diversify your portfolio and guard against risk and uncertainty (strategic portfolio risk management and mitigation). You are mistaking, however, if you make precious metals like gold and silver a very significant part of your portfolio in most cases. e to edit.
Gold, silver, and other precious metals aren't productive assets - they effectively just sit around
As ultra-successful investor Warren Buffett has stated and as any good investor knows, gold and silver (and pretty much every such precious metal and commodity) are not productive assets - they just sit and look pretty. Unlike a successful business, they don't make more money, as illustrated by the below example.
If you had $1000 to invest today and you purchased silver bullion with the entire sum, the value of your initial $1000 investment in 10 years would depend solely on the supply and demand for silver. That's it. If you invested that money into buying a share of a successful and profitable business, however, the value of your $1000 investment in 10 years would depend on a lot more than the supply and demand for a share of that business. It would depend on that of course, but it would also depend on the business's management, the innovation that occurred within the business, how effectively the business model and the business's plans were carried out, etc. Over those 10 years, your silver would just be sitting there but the business would be working hard to sell products or services, grow, and become more efficient. It may turn out that the investment in the business was a bad idea, but that wouldn't be because of the nature of the investment. It might be because of other factors such as a recession, depression, poor management, an act of God, etc. If your investment in the silver bullion turned out to be extremely profitable, however, it would only be because of the speculative nature of investing. You would have guessed correctly that market forces would cause an increase in the price of silver. Over those ten years, your silver bullion would have been sitting there, but the business will have been hard at work creating value and serving its customers.
A quote from Warren Buffet on gold and silver
Here's a quote from world-renowned investor Warren Buffet - he can put it better than anyone can:
"Today the world's gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce -- gold's price as I write this -- its value would be $9.6 trillion. Call this cube pile A.
Let's now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world's most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?
A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops -- and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond."
Precious metals like gold and silver may help diversify your portfolio and mitigate risk, even if they aren't great standalone investments
Although not good for long-term investing strategies, precious metals like gold and silver may add some risk-mitigating diversity to your portfolio if done correctly.
In many instances of economic downturns and recession -- but not all instances -- precious metals and commodities outperform traditional asset classes such as equities. Even real estate usually doesn't perform well during a recession. But, precious metals occasionally experience an uptrend during times of economic uncertainty because there is a perceived level of safety in them.
The perceived safety may arise from many reasons, which might include:
And now, given the rise of cyrptocurrencies and crypto assets to quasi-mainstream financial assets, we're dedicated to providing quality, relevant, and interesting material on cryptocurrencies and cryptoassets. Articles on Bitcoin, Ethereum, Ripple, Cardano, and many more cryptocurrencies and cryptoassets can be found on Pennies and Pounds - all that in addition to a plethora of information on what cryptoassets are, how the entire crypto industry came to be, blockchain/immutable ledger technology, mining, proof of work, proof of stake, and how to prudently invest in crypto if you are so inclined (based on your risk tolerance and ability to withstand the volatility that will come with a crypto portfolio).