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How to Avoid Concentration Risk at All Costs (So It Doesn’t Cost You Everything)

02/14/2019

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There are a number of risks associated with investing if you do not diversify your pot of stocks and bonds to capture a larger share of the market. Selecting securities, stocks and bonds, that span a wide range of sectors is a good way to secure yourself from a market downturn.
Investors need to remember to give themselves options in the form of diverse investments in case the market turns on them. The market’s conditions change frequently, and investors should be prepared to move from a bull run in some market sectors to a bear market as the tide changes.

Here Are Some Reasons for Concentration Risk

One big reason for concentration risk is market performance chasing. Investors who go after trends that are reported frequently often tend to lag behind indexes as well as the larger stock market. This is mainly due to the market being fast paced and consistently moving.

What Is the Danger in Performance Chasing?

Performance chasing leads to lower portfolio results for investors because a larger share of the market is making the same investment calls.
World events and financial news have a significant effect on the way the market moves due to changes in investor sentiment. If a sector, or even more narrowly a particular stock, is over performing then it would likely to be over-valued at some stage. This can lead an investor to spending more on purchasing a stock in that sector, since it is overvalued, and lead to losses in the long run. Losses are highly likely to occur during a market dip.

Over Confident About a Stock or Sector?

When a stock does particularly well in your diversified portfolio, there may be an urge to increase your spending toward that stock or its particular sector. However, this would be another concentration risk.

The reason for the risk is that moving further toward a stock would lead to an imbalance in the portfolio. Just because the stock is doing well, does not mean that gains are guaranteed to last. The lesson is to do some digging and understand more about where the stock is heading and why.

By doing the legwork on researching a stock and its sector, you can make an informed decision about whether to invest with confidence. Looking at gains alone will lead to poor investment choices.
Additionally, be careful about buying too much of a particular stock or sector, since creating an imbalance in your diversified portfolio can move contrary to your investment goals.

Companies Offering Stock Options

Investors should be wary of putting away too much toward stock options in the company they work for due to the volatility of the stock market.
Despite having a familiarity of the company and its products, investors should be concerned about the value of its stock. Famed investors understand that an individual stock does not really represent an investment in the company, but a representation of it on paper.

Investor sentiment can drive a stock price down despite the company having a bright future and a competitive line of products. Additionally, market sentiment can also play a part in changing the tide of the stock’s price.

It is wise to keep your portfolio diverse rather than focusing on a single stock that you may feel you know because of your familiarity with the company.

Investments That Are Difficult to Liquidate

The key advice continues to be diversification when it comes to building an investment portfolio; however, understanding the kinds of securities available to you is important too. Some securities are easier to deal with than others, especially during market downturns.

Investments that are difficult to move as well as monetize are hard to liquidate. The level of liquidity of an investment depends on how easily it can be bought and sold. Some difficult assets to liquidate can include real estate and private equity. These assets are difficult to sell during a market downturn.

Investors holding illiquid assets are stuck to face the losses as well as the gains in the long run regardless of whatever way the market shifts.

Addressing Concentration Risk with a Plan

The best way for an investor to tackle performance chasing risks is with a solid investment strategy. Many successful investors plan before investing, including Warren Buffett and Jim Cramer, and put particular emphasis on diversifying their portfolios. These successful investors, and other like them, build up tailored portfolios to meet their long-term goals and account for their level of risk tolerance.

The other factors that go into planning a diversified portfolio, include yield objectives and time horizons. Long time investors are seasoned at understanding how much they can earn over the course of an investment given that all the factors that were accounted stay constant.

What Elements to Consider When Investing

In order for an investor to fully understand the value of a position held, an investor needs to understand the liquidity and diversity of the assets in a portfolio. Each element is important in order to understand what options are available to an investor if a market downturn takes place.

Asset Liquidity

It is important to be able to sell an asset on short notice. And some index investments can be difficult to sell during periods of market downturn. The movability of an asset and how easy it is to sell marks the liquidity level of that asset. Some assets are far easier to sell than others.

In cases of assets that are difficult to sell, you may have to settle for a lower price point than when you bought it. In market downturns, if your asset is difficult to move because it is real estate or some other illiquid asset, then your options would be to either stick it out in the long run or sell below actual value.

Asset Diversity

Additionally, it is important to understand how to diversify a portfolio. One investment strategy that gets used often is to buy a number of mutual funds over years at a time. However, some investors tend to do this without considering how those assets fit within their investment portfolio. On top of that, investors might also miss how buying the mutual fund fits with a larger trading strategy and proper diversification.

The practice of investing in mutual funds blindly can lead to significant overlap in your portfolio because you could be holding the same asset within multiple funds. Some mutual funds are bound to be made up of similar assets.

The overlap and buildup of similar assets could be a concentration risk for investors. Holding mutual funds that have many of the same assets can lead to an imbalance in your portfolio, which can lead to heavy losses in a market downturn.

Last Thoughts on Addressing Concentration Risk

Concentration risks can be minimized by identifying, measuring, and managing your risk effectively. Make sure to take all these elements into account while forming your strategy to curb risk.

Form a strategy that takes into account both the type and magnitude of the risk you can be exposed to and then evaluate how to minimize the risk. Identify some of the various options you may have to minimize the risk. These options might include your own finances that you have put aside, or the way you would like to diversify your portfolio to meet your long-term goals.

Take into account the variability of financial situations as well as market situations and how each of those can change at random. While it is important to have a plan of action, it is also important to be flexible to changes in your situation. For example, finances can change depending on your job while the market can change depending on news and investor sentiment.

A consistent approach to risk management is the key to curbing concentration risk in your portfolio and achieving higher earnings in the process. Follow the approach and continue to evaluate your situation and portfolio on a regular basis – perhaps every economic quarter – to make sure you are on track.

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