Concentration Risk: What is it? How does it show up in your portfolio?

Author’s Note: This post is Part 1 of a deep dive I’ll be doing into Concentration Risk; what it is, how it happens, and what you can do about it. Part 2 will describe how you can come up with a strategy to tackle your concentration risk.

Photo by Alizee Marchand on Pexels.com

“Don’t put all your eggs in one basket,” the proverb goes – because doing so will leave you overexposed to any risks to the one basket. The same principle applies to investing. Specifically, portfolios with concentrated investments (where a high percentage of someone’s net worth is tied to a single holding) present higher risks than diversified portfolios with similar expected returns.

This seems somewhat obvious, but a shocking number of my friends and acquaintances (almost all of whom are otherwise highly intelligent people) nevertheless happen to have portfolios with concentrated positions in one or a few investments (mostly Tech stocks or Crypto). While the rational part of our brains tells us that this is bad, our cognitive biases conspire against the rational parts of our brain to keep us in concentrated portfolios for far longer than we should be in them.

How do people end up with concentrated portfolios?

There are many ways to end up with concentrated investments. Some of the most common ones are:

Public Company Employment (Stock Grants, Employee Stock Purchase Plans, etc.)

A sneaky way to end up with a concentrated portfolio is by working at a public company. With regularly vesting equity grants, Employee Stock Purchase Plans, and the tax advantages that come with holding company stock in ones 401ks, it becomes very easy to gradually accumulate a concentrated portfolio in that company, sometimes without even being conscious of it.

IPOs and Acquisitions

The dream of anyone working at an early stage company is for that company to be wildly successful and either go public or get acquired. All the equity you’ve earned and been unable to trade or value so far is suddenly available to you. You now have a highly concentrated portfolio. The saving grace here is that it’s obvious to you that this has happened.

Appreciation

Even relatively unconcentrated investments have the potential to become concentrated over time. Imagine you correctly predicted in 2007 that the introduction of the iPhone would propel Apple’s stock to rise meteorically, that Bitcoin would appreciate in value, or, more recently, that Tesla was more than just another car company. The appreciation of your investments in those opportunities would cause you to have concentrated positions. And the insidious thing about gaining concentration this way is that it’s easy to infer that you should have started with an even more concentrated position in those investments—an understandable if misguided interpretation.

Why do people hold on to concentrated positions longer than they should?

The investment is down

“The stock had a higher price in the past and I’m waiting for it to come back…”

You don’t want to realize a “loss” on what is a significant portion of your net worth at this moment because you’re still holding out hope that you’ll break even. Anchoring bias will also cause you to believe that the stock is worth more than it actually is.

You tell yourself that you would definitely sell right away if the investment was up, but it absolutely doesn’t make sense to sell now.

The investment is up

You want to hold on so that you pay the lower long term capital gains tax rate instead of having your gains taxed as ordinary income. You might also be tempted to continue to bet on the proven winner. You tell yourself that that’s ok because you’re “playing with house money” at this point.

You also tell yourself that you would definitely have sold if the investment was flat or down instead, but obviously it doesn’t make sense to sell now.

You know better

Your knowledge of the company or industry makes you better equipped to value its future than the market at large. You believe in the future of the investment but might not know how to rationalize that expectation with the overall risk that you’re taking. 

Market Risk

You don’t want to divest a large portion of your portfolio at one time, only to find out that the market was up the next day. That fear prevents you from selling at all. Or you might sell a small portion one day, and plan to sell more gradually. But then life gets in the way, or the investment goes down, or up, and then you hold on to it anyway for the reasons discussed above.

We’re bad with probabilities

Risk is fundamentally about probabilities – which humans are really bad at estimating. Instinctually we treat things as being either nearly impossible or nearly inevitable. That makes it hard for us to make decisions about things involving probabilities without a solid framework for making those decisions. You might decide to sell 50% or 70% or 30% of whatever investment you have a concentrated position in without any real basis to those numbers. Your knowledge that those numbers have no basis also reduces your conviction to follow through.

Omission Bias

We judge harmful actions as worse than harmful inactions, even if they result in similar consequences. When faced with uncertainty about what the best thing to do is, we prefer to shut down and just do nothing. The severity of getting it wrong is even more significant when you’re talking about a significant portion of your net worth. Paradoxically, that causes you to do nothing.

How do I get out of my concentrated portfolio?

Even just being aware of your cognitive biases goes a long way towards overcoming them. Stay tuned for a follow-up article where I will talk about how to come up with a strategy that you’re likely to follow through on for diversifying your portfolio.

Questions? Comments? Did I miss anything? Feel free to reach out to us at hello@prosperowealth.com if you’d like to discuss this. We’d love to hear from you.