Eggs, meet basket.
Concentration risk has nothing to do with your ability to think. It is when your net worth is concentrated or heavily tilted towards any specific investment or class of assets. Concentration risk means that you’re less diversified, and therefore the assets in your portfolio are highly correlated. A high correlation means that the value of your assets will generally rise and fall in lockstep.
In theory, a diversified portfolio is less correlated. For a portfolio to be less correlated, it will have assets that represent many varying asset classes that may behave differently under a wide range of underlying market and economic conditions.
In of my career, I’ve seen massive amounts of wealth built and wealth lost due to concentration. There are two types of portfolios that I see where correlation risk is prevalent. The first is people who either own a company or have received large sums of corporate stock as a result of their employment. The second is with real estate investors who think that bricks and mortar are the only option.
For those with concentration in a single company, whether you own it all or have received options and grants that have begun to really add up, recognize and understand what that risk means to you.
For employees who have accumulated large amounts of shares, beware. While this may have worked great in the past, it isn’t guaranteed to continue to perform well. Should things turn for the worse, the effect on your wealth and ability to become financially independent may go up in smoke with one bad news report or scandal. Conversely, just because you begin to diversify and add other companies, industries and asset classes to your portfolio, there is no guarantee of better results or less downside. Most scholars would agree, however, that statistically you may still lower risk through greater diversification.
If you own a company that makes up the majority of your net worth, you’re also exposed to concentration risk. Most successful business owners have a hard time seeing this risk because they are so close to their business. It is even harder to act when your company has been very successful and delivering superior returns and appreciation. Nevertheless, it may still be a good idea to begin creating net worth outside of your business with your retirement plans, cash and after tax investments. Beyond concentration risk, when the majority of your net worth is comprised of a closely held business, you may be setting your family up with a challenging estate plan and problems.
For real estate investors, selling to diversify is the toughest part. You may have income taxes as a hurdle And facing the reality that your diversifying choice may not perform like your real estate did. Consider starting by investing excess cash flow into a non-correlated asset and selling what may be your more challenging properties.