What is concentration risk?

Concentration risk is the chance of losing money because you have put too much of your wealth into one asset or market. Concentrating your investments like this can lead to significant losses if something terrible happens to that asset or market.

Concentration risk usually comes from having a massive position in a single asset. This means you have invested much of your money into one thing, like a particular stock, bond, or piece of real estate. If the value of that asset goes down a lot, you could lose a big chunk of your wealth.

Concentration risk can also come from too much exposure to one particular market, even if your money is spread out across different assets within that market. For example, let’s say you have investments in several other tech startups. You may think you’re diversified, but your startup investments could tank simultaneously if the whole tech industry hits hard times.

The dangers of putting all your eggs in one basket

There’s an old saying that you shouldn’t put all your eggs in one basket. This means it’s risky to concentrate all your resources in one place. If you drop that basket, all the eggs will break. But if you spread your eggs across multiple baskets, one dropped basket won’t ruin you.

It’s the same idea with investing. You’re in big trouble if you put a considerable portion of your money into one stock and that company goes bankrupt. But if you invest in various stocks across various industries, one company failing won’t hurt as much.

The problem is that it can be tempting to concentrate your investments, especially when a particular asset or market is doing well. Let’s say there’s a hot new tech stock that has doubled in price in just a few months. You might be tempted to go all-in on that one stock. But if that company is just a flash in the pan and its stock crashes back down, you will seriously regret that decision.

How concentration risk leads to other risks

Too much concentration in your portfolio doesn’t just expose you to the risk of that specific asset or market going bad. It can also lead to other types of investment risks.

Liquidity risk

One of these related risks is liquidity risk. Liquidity refers to how easily you can sell an asset for cash. Some assets, like popular stocks, are highly liquid because many buyers are always ready to purchase them from you. However, other assets, like real estate or ownership stakes in private companies, can be hard to unload quickly.

When you have a massive position in an illiquid asset and need to sell it fast, you might have to accept a much lower price than that asset is worth. This is liquidity risk – the chance that you won’t be able to sell for a fair price when you need the money.

This risk gets amplified when you have a concentrated position because trying to sell a massive amount at once will move the market against you. If you need to unload 10,000 shares of a thinly traded stock, the supply of shares you’re putting out there will far exceed the typical demand from buyers. The price will plunge as you liquidate.

Market risk

Concentration also exposes you more to overall market risk, which is the chance that an entire market will decline in value. Even highly diversified portfolios aren’t immune to market risk because when the whole market goes down, it tends to pull most assets down to some degree. But concentrated portfolios get hit much harder.

For example, say there’s a stock market crash and the whole market drops 20%. If you have a diversified portfolio with a little bit of everything, you’ll likely see a painful but manageable decline of around 20% as well. But if your portfolio is concentrated in a few stocks that are especially exposed to market downturns, you could be looking at a devastating 50%+ loss.

Managing concentration risk

Given the dangers of concentration risk, investors need to manage and mitigate this risk in their portfolios proactively.

Diversification

The primary way to combat concentration risk is through diversification. This means spreading your money out across many different assets and markets, so no single holding has too much influence over your total wealth.

A well-diversified portfolio will contain a mix of different asset classes, such as stocks, bonds, real estate, and cash. Within each asset class, the portfolio should have a variety of individual holdings. For a stock portfolio, this means owning shares of companies in different industries, of different sizes, and from different geographies.

It’s important to realize that you can’t avoid concentration risk by just investing in many different things. True diversification requires carefully selecting assets that don’t all move in tandem. During the 2008 financial crisis, many investors thought they were diversified because they owned many different assets: stocks, real estate, corporate bonds, etc. But when the financial system nearly collapsed, all those asset classes collapsed. That’s because they were more correlated than they appeared.

Risk management

In addition to diversification, robust risk management is key to keeping concentration risk in check. Even a portfolio with many holdings can become dangerously concentrated if a few positions balloon in size due to strong performance.

Investors need to regularly monitor their portfolios for concentration and rebalance when necessary. For example, let’s say you started with a nicely balanced portfolio of 50% stocks and 50% bonds. However, after a few years of a raging bull market, the stock portion has grown to 70% of the portfolio. It’s time to sell some stocks and buy more bonds to get back to your target asset allocation. Otherwise, you’ll be overexposed to stock market risk.

Risk management also means planning what to do when downturns inevitably happen. If you manage your risk correctly, you’ll be able to ride out market crashes without having to sell assets in a panic. Having a cash cushion to draw on for living expenses helps prevent the need for ill-timed sales.

Know your risk tolerance

The right amount of concentration risk depends on your individual goals and risk tolerance. Some people can take more risks than others. If you’re young and investing for a retirement that’s decades away, you have time to recover from market downturns. So, you might take on a bit more risk in pursuit of higher returns.

But if you’re close to retirement, you’ll want to play it much safer. A significant loss before you start drawing on your portfolio can derail your retirement plans. So as you get older, it’s wise to shift into a more diversified, less volatile portfolio.

No matter your age or situation though, it’s rarely a good idea to take on excessive concentration risk. Being too exposed to any asset or market is just asking for trouble. By spreading your bets around, you can participate in the market’s long-term growth without risking catastrophic losses.