A common theme among wealthy individuals is the realization money earned easily can be lost just as quickly. There is a million ways to get wealthy, but staying wealthy is just as important.
Individuals invested in the stock market have made fortunes in recent years. The current bull market, especially in high growth stocks, have rewarded investors who were heavily concentrated in those stocks. With the high reward comes high risk and some people won’t be able to hold on to their new fortune.
Having too much of your net worth in one investment can expose you to concentration risk. Concentration risk is the risk an investor will suffer from lack of diversification, investing too heavily in one industry, sector, or stock. Below I’ll show you examples of where concentration has been successful and other times when it was costly.
Spotting Concentration
Single Stock Exposure
Anyone who has stock based compensation is likely to have some level of concentration in their investment portfolio. We recommend taking advantage of these plans because they often come with 5-15% discount on their stock. Below are two examples of how owning company stock can work great and how it can end poorly.
Apple is one of the most well-known stocks. Historically it has done well, but even Apple has had periods are large declines. Being able to hold a stock through multiple 50% drawdowns not knowing if it will ever bounce back is easier said than done.
Next is General Electric, it was the largest stock in the S&P 500 for the majority of the mid-1990s through the mid-200s. As recent as 2010, it was the 5th largest company in the U.S. stock market. During that time, many people believed General Electric was a great stock to own. Today, their stock is down 77% from all time highs. Employees and investors who didn’t diversify most likely have huge loses.
It always fun talking about big winners but it’s worth remembering many of those big winners may eventually become the biggest losers.
Index Funds
Many people assume index funds are well diversified. As of today, technology makes up 24% of the S&P 500 index. If you work in technology, your industry makes up a considerable part of the stock market. As a result, if you are only invested in index funds, you could easily develop a high level of concentration in tech. Having both your investments and income overly exposed to one sector can be costly. There was a similar situation in the dot-com crash, where people not only lost substantial value in their investments but also lost their job.
Real Estate
As you are probably aware, the residential real estate market is red hot. If you have multiple rental properties and are looking for an opportunity to diversify into other assets, now might be the time to sell one. Many of us lived through the 2008 housing bubble and remember how hard it was to sell real estate. Not saying we will have another 2008, but it would be wise to make sure you are in position to withstand a down year in real estate.
Commodities
Commodities are often used as a hedge against inflation and a store of value. The most common commodity we see people purchase is gold. Historically, their returns have been lower, and they have had large drawdowns as well. As recent as 2015, the price of gold declined 45% from it’s all-time high set in 2012. The past 30 years gold has returned 361% and the S&P 500 has had a total return of 2,280%. Commodities can be used as a hedge in a portfolio, but it’s not recommended to keep a high exposure.
What Should You Do?
Diversify
When everything is going well it is easy to lose discipline. Sure, some people hit the jackpot being heavily concentrated in an investment. But for every person who does succeed there are a hundred people who don’t. There is no reason to be taking unnecessary risk when you are pursuing your own personal goals. To reduce your risk, diversify across different sectors and asset classes. If you still want to gamble on a single investment, make sure that you can withstand the declines that come with it.
Have a Plan
Determine what investments are appropriate for your desired goals and needs. Create a plan for your company stock and an appropriate allocation. As you get closer to retirement reduce exposure to high-risk assets. There will never be a way to guarantee against loss when investing but there are ways you can reduce your risk. Having a plan that you can stick through during up and down markets is key to long term success.
Work With a Professional
You can give people all the knowledge you need in the world and they will still make bad decisions. Sometimes people need to learn from their investment mistakes before becoming a better investor. Other people seek help of a professional who can lead them in the right direction before making costly mistakes. A good advisor has the tools and research to show you if your investments are appropriate for the goals you are looking to pursue.
Sources / Disclaimers:
Source for drawdown charts: YCharts
Please consult your financial advisor regarding your specific situation. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. All investing involves risk including loss of principal. No strategy ensures success or protects against loss. This information is not intended to be a substitute for specific individualized tax advice. We suggest you discuss your specific tax issues with a qualified tax advisor.
The Standard & Poor’s Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
Investments in real estate may be subject to a higher degree of marker risk because of concentration in a specific industry, sector, or geographical sector. Other risks can include, but are not limited to, declines in the value of real estate, potential illiquidity, risks related to general and economic conditions, stage of development, and defaults by borrower.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk,
