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).
You can't predict when a recession will hit, but you can be sure that a recession will come at some point. Speculation on the exact timing is a fool's proposition, but indicators exist to indicate when the overall market is overvalued and when a recession is more likely. Preparation for a recession is wise and simply ignoring overall market valuations will cause you to (1) not be ready to take advantage of investing opportunities a recession presents and (2) be potentially exposed in troubling ways due to improper diversification. The below 3 strategies are excellent ways to prepare for a recession.
1. Start Piling Away Cash for Cheap Stock Purchases When the Recession Hits
Cash is dry powder to investors and without some set aside you simply won't be able to take advantage of a recession. Cash will allow you to buy good stocks at deep discounts when the market falls during a recession.
Do you notice how the first thing we're advocating in terms of recession preparation is something that will allow you to buy more stocks instead of something that is meant to protect you? Obviously, you want to be protected in severely adverse market circumstances as an investor, but the most important thing about a recession isn't what it does to your portfolio in the short term, but the potential it has to boost your portfolio in the long term. A recession allows you to buy a lot of good quality companies at deep discounts - sometimes you see a price to earnings (P/E) ratios of indices such as the S&P 500 can drop below 10, indicating an extremely undervalued market overall.
Without having cash piled up ready to toss into good companies -- it's key that you only buy good companies -- you will miss out on potentially outsized gains due to inevitable market recoveries. The great thing about recessions is that you don't even have to pick individual stocks - something that is not recommended for novice investors or those with low-risk tolerances. Purchasing indexes (eg. S&P 500 or the Dow Jones) via broad mutual funds or ETFs will allow you to at once diversify and benefit from future recoveries. Purchasing the Dow Jones at the bottom of the 2007/2008 Great Recession would have created a 300% + return over the course of a decade without having to take on the risks of owning single stocks or having to put in the effort to pick them.
When the market seems overvalued in terms of market P/E ratios, in terms of timeframe since the last recession, or in terms of high-quality research/opinions, it might be a good idea to slightly pull back on some of the more speculative investing you're doing to put aside cash. You'll want enough cash so that you can comfortably enter positions at lows and then continue buying more and more if markets continue to drop. This abundance of cash will allow you not to think about timing the market -- something that you will not be able to do -- but will instead allow for an aggressive dollar cost averaging strategy once things start to decline until things start to turn up again.
2. Properly Diversify Your Portfolio so it Can Withstand a Recession
To make your portfolio more resilient to recession declines you'll want to diversify across:
You don't want to hold just US firm and you don't want to hold firms only in a single industry (eg. tech). Instead, you want to hold a broad portfolio of high-quality firms from around the world and from different industries. Some regions and industries will be more resilient than others and this will affect your portfolio. additionally, some firms will go bankrupt in recessions - hopefully, you don't own any such firms because you've done proper due diligence but some things are very hard to predict. You'll want to not be tied to a single industry, a single location, or a single firm when the market turns downward so that a single disastrous event will not affect more than a small portion of your portfolio and so that you can survive as an investor into the recovery.
A great way to diversify is through the use of mutual funds and ETFs, but diversification is also achievable through simply building your own high-quality stock for experienced investors - moderately experienced investors should not try this (novice investors shouldn't even think about this).
3. Buy Protective Puts on the Market (ONLY FOR ADVANCED INVESTORS)
If you don't know what a protective put is, this section is not for you at all and you should skip tot he end of the article.
If you do know what a protective put is but wouldn't be properly considered an advanced or experienced investor, you can read this section but you should not engage in this activity because it could cause a needless drain on your portfolio and a false sense of security.
If you're an advanced investor, you probably already know this strategy, but we'll remind you again. Protective puts are simply put options - they are called protective because of the context they are being used in. You can buy such protective puts on the overall market via market proxy (eg. S&P 500) in order to profit from market declines.
One way to execute such as strategy is to buy monthly out-of-the-money puts on the market proxy via a mutual fund or more likely an ETF. These should be out-of-the-money because what you're buying here is a form of insurance in case the market drops significantly - you're not trying to speculate. Out-of-the-money puts will be worthless if the market goes up or doesn't move much but will increase in value in a significant market decline. You can buy them for a reasonable term - monthly, quarterly, yearly but shorter repetitive purchases might be better because you're less exposed to the option's time decay.
Options are valuable - that's why you can literally pay for them when you purchase financial options (eg. put options or call options). Options are valuable because they allow you to decide in the future whether to do something or not to do it - you will decide at that future date based on what is going on at that future time. Although you can't know what the future will be like today, options allow you to postpone the decision (in a way) until you actually do know.
For example, when you buy a call option on stock X you are paying a premium for the right to decide in the future whether or not you want to buy stock X at the predetermined strike price. Effectively, you're paying a premium today to lock in the purchase price. You pay that premium (and so do millions of other market participants) because such a thing is inherently valuable. How valuable is it? That's a far more complicated question and beyond the scope of this article - the question of how to value a financial option is a complex one that involves complex mathematics.
Just like a financial options, options in life are valuable too - that's why you should attempt to increase the options in your life. You should attempt to make decisions with attention to the optionality inherent in them. If you have to choose between two different paths, be mindful of any inherent options that are imbedded in the choices. These inherent options can add real value to the decisions and they should be ignored.
Let's discuss one simple hypothetical example to better illustrate the point made above. Let's say you are choosing between two houses that are equal in every respect except...
Now, you might not want to rent out any rooms NOW, but House 1 has imbedded optionality that House 2 doesn't. Should you need the extra money, should your lifestyle change, or should rents go up a lot in your area, you might want to rent out a room or two in your house. House 1 allows you to EXERCISE that option should things unfold in a way to make it desirable to rent out a room or two. Just as you would exercise a financial option if the market price of the underlying is greater than the strike price, you can exercise this embedded option should it be worthwhile for you to do so.
Therefore, all else being equal, House 1 should be more valuable to you and to the market due to the inherent optionality embedded within it - an optionality that doesn't exist in House 2.
Investing vs. Speculating: Understand the difference so that you aren't taking needless and fruitless risks with your financial portfolio
What is investing? An attempt at a definitive definition.
Here's our definition for what investing is:
Investing, in the financial sense of the word, is the deployment of capital (usually money) into the purchase of shares, purchase of assets, development of commercial ventures, or other financial schemes in order to obtain a return on that deployed capital with a reasonable expectation (grounded in some sort of reasonable analysis) that the risk-adjusted or expected return is positive.
That's a long and somewhat fluffy definition, but any definition that would cover the broad range of activities that could properly be classified as investing will be somewhat fluffy. Let's break down the main elements of that definition and discuss them briefly.
...the deployment of capital...
This means you use some sort of capital (usually money) to invest. Without using or committing capital, you're not really investing. You can invest your time and energy into things, but that wouldn't qualify as financial investing. You must deploy capital in some way for your activity to properly be called investing in the financial sense of the word.
...or other financial schemes...
Investing requires the deployment of capital in a specific way. It requires that the capital be used to either purchase shares of a firm (the firm can be publicly traded or privately held), purchase assets (purchasing gold, Bitcoin, fine rugs, or fine art might qualify as asset purchases), develop commercial ventures (start a business or develop a new office building), or to pursue some other type of financial scheme. It's not easy to make an exhaustive list of the other possible financial schemes because there are many possibilities. For example, a properly documented and agreed upon private loan to an acquaintance can qualify as an investment. The purchase of various derivatives products might qualify as an investment as well. Even the purchase of rare grapes for the purpose of creating a unique wine could qualify as an investment. It's impossible to describe every possibility here, of course, but this should give you a general understanding of what I mean by a financial scheme.
...in order to obtain a return...
Investing requires that the deployment of the funds is done to obtain some financial return. If no return is expected or desired, then the deployment of capital is more like a donation or a purchase depending on the circumstances. Financial investing requires that it is done for the purposes of growing your capital base by receiving a return on the invested funds.
Investing requires that we are reasonable in our expectations of the financial return from our endeavor. If we are unreasonable or foolish, it's not investing in my opinion. A reasonable person using reasonable analysis techniques (they don't have to be complicated, just sound and reasonable) should be able to agree that a positive return is possible. This means that if unfounded, biased, or inappropriate techniques of analysis are used in order to determine what the potential return is (either expected return), it is not investing in the proper sense of the word. For example, using deeply incorrect assumptions that you know don't make sense to calculate your expected return wouldn't hold up to this standard. You wouldn't be investing here, but would instead be fooling yourself and possibly speculating. Additionally, not dong any analysis whatsoever before deploying capital would preclude the activity from being called investing. The analysis doesn't have to be complicated (although deeper analysis is likely better), but some sort of thought must be given to what is occurring if we are to call the activity investing.
...that the risk-adjusted or expected return is positive.
This point speaks to how we calculate the return. We state that the return has to be positive, but we need to know how to calculate the return. In calculating the possible return, a more sophisticated investor should adjust for risk, calculating what is called the risk-adjusted return or the expected return (these two names can generally be used interchangeably in a non-academic or unsophisticated setting). There are complicated mathematical formulae for calculating risk-adjusted numbers, but what is meant here is something more basic: the return you expect to get should from your investment should be the adjusted for risk, with less probable outcomes discounted more intensely. In other words, the return can be thought of as a weighted average of the possible returns, each return weighted by its probability of occurrence. Going further, this means that investing requires that the expected return is positive. That expected return might never occur, but at the outset (when we deploy the capital) the expected return should be positive. No rational individual would deploy capital into a financial scheme that has a negative expected return.
Speculation isn't investing; neither is work or saving!
Investing, in the financial sense of the word, can be distinguished from other uses of capital or energy. Investing is not:
Keep the definition of investing in mind to avoid foolish speculative bets or to confuse saving with investing
In conclusion, we see that investing is a specific type of deployment of capital and is distinguished from work, saving, and speculation. Keeping the definition of investing in mind could help us differentiate between investing and speculation by applying the definition in a disciplined way before we deploy our capital. Investing is a fundamental part of individual wealth-building and it allows for a society to grow and prosper, but it should be done wisely and carefully so as to make sure that foolish bets are not being taken.
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).