Are Concentrated Assets More Risk than Reward?

Many wealthy individuals hold concentrated asset positions, but this strategy requires great risk awareness.

Concentrated assets rightly set off some alarm bells by challenging the golden rule of diversification. Spreading risk across a wider portfolio of interests mitigates the potential fallout if one investment class or vehicle hits hard times, making diversification a best practice.

It’s logical to wonder why any investor would choose to create a concentrated position of higher-risk assets. They may have a lot of faith in their employer and sink most of their investments into the company. Some individuals may possess generation-spanning wealth that has traditionally been tied to a particular sector or asset class. Others may simply be hoarding one asset, convinced they’re onto a winner.

Concentrated assets do have some potential advantages. But with wealth management, it’s usually all about maintaining a proper balance.

The advantages of concentration

What precisely constitutes a concentrated position is a contested number, with some advisors regarding anything higher than between 5 and 10 percent of investable assets as qualifying.

While diversification is a best practice, concentration can sometimes be a solid strategy when it’s executed strategically. The core reasoning here is neatly captured by the circle of competence, an approach tried and tested by Warren Buffet and outlined in his lengthy Shareholder Letter of 1996. Basically, the circle of competence cautions investors to draw a firm line between what they know and what they think they know.

The asset equivalent of “stay in your lane,” it treats concentration in assets/markets you’re familiar with as a potentially wise move—in contrast to casting a wider investment net over areas in which you have little interest or experience.

Active investors may find themselves tied up in multiple interests solely for diversity’s sake, which can limit their ability to make informed and confident decisions. Viewed through this lens, a concentrated position can be a more comfortable and potentially profitable one—when it’s backed by experience in and familiarity with a particular area of investment.

There’s another argument against overly broad diversification that resonates with some active investors. The more diversified a portfolio is, the more closely its performance will mirror the market. And concentration in a well-performing sector can reap financial rewards that a less-centralized strategy would not.

Reasons to be cautious with concentration

Risk tolerance is central when considering concentration. A lack of diversity does ultimately contradict one of the guiding rules of investment. It increases portfolio volatility and, if a position fails, dramatically increases the potential for losses that may range from significant to extreme.

Lack of liquidity is another problem. Too much emphasis on a single position may prove highly restrictive on an investor’s ability to sell or transfer the assets into other areas. If an as-required sale is possible, there are cases (as with variable annuities) where a charge for early sale may be incurred. Combine that with a likely lower-than-desired price—you need to liquidate quickly for a reason!—and holding or disposing of the investment becomes a costly consideration.

And, as heretical as it may sound, there is room to question Warren Buffet’s wisdom regarding the circle of competence. Namely, an investor maintaining a concentrated position in an area they’re very familiar with may become overconfident.

For example, just as an individual may heavily favor domestic stocks over international ones—a position which could stem from familiarity bias—they may also choose to invest heavily in their employer. This is an entity with whom they’re not only familiar but may have personal attachment to.

Investing should always be firmly grounded in each individual’s personal goals and their present reality and risk tolerance.

Concentration, diversification, and other considerations in a customized investment strategy

The essential takeaway here is never to forget another investing maxim: past performance is no indication of future returns. No matter how strongly a national economy, industry, company, or asset class has performed—and regardless of how many others are leaping onto a particular investment bandwagon—tides can turn and leave once-lucrative concentrated positions high and dry.

The Lindberg & Ripple team can provide impartial, transparent investment advice to advance your interests and develop a strategy that’s right for your circumstances. Get in touch with us at the link below to benefit from our three generations of experience.

Lindberg & Ripple offers customized wealth management, investment, and insurance solutions to wealthy families and successful businesses. We help our clients craft a comprehensive wealth planning model to achieve their financial goals with minimum fuss and maximum savings. Connect with us to learn more.
 
This information is obtained from sources that are believed to be reliable, but we make no guarantees as to its accuracy. This material is for educational purposes only. Educational material should not be construed as legal or tax advice and is not intended to replace the advice of a qualified attorney, tax advisor and plan provider. By accessing any links above, you will be connected to third party web sites. Please note that Lindberg & Ripple are not responsible for the information, content or product(s) found on third party web sites. Investments in securities involve risks, including the possible loss of principal. When redeemed, shares may be worth more or less than their original value. Diversification does not ensure a profit or protect against loss in a declining market. Securities and Investment Advisory Services Offered Through M Holdings Securities, Inc. A Registered Broker/Dealer and Investment Adviser, Member FINRA/SIPC. Lindberg & Ripple is independently owned and operated. # 3348621.1