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Concentration risk occurs when a large portion of a portfolio's holdings is tied up in a particular investment, asset class, or market segment relative to the overall portfolio. Left unchecked, it can leave an entire nest egg exposed to the fortunes of a single company, sector, or asset type. Concentration risk can build up through several common paths:
- Intentional Concentration — a conscious decision to invest a significant amount of money in a given asset or asset class, often on the belief that it will outperform its peers or a broader index.
- Company Stock Concentration — common when an employee invests retirement savings heavily in an employer's stock, whether through a 401(k) match, an employee stock purchase plan, or vested equity compensation.
- Correlated Assets — holding investments within the same field or industry, so that the performance of one holding directly tracks another, even if the account appears diversified on paper.
- Illiquid Investments — non-traded REITs, private placements, and other complex or illiquid products that are difficult to sell quickly, and often difficult to value accurately, when markets turn.
- Asset Performance — when one investment far outperforms the others in a portfolio, its share of the total grows disproportionately large, even without any new money being added to it.
The danger of concentration is straightforward: when portfolio performance depends heavily on one or two investments, sectors, or variables, a decline in that single holding can produce outsized losses that a well-diversified portfolio would have avoided or cushioned.
How to Manage Concentration Risk
FINRA continues to recommend a few core practices for managing concentration risk:
- Diversify across and within asset classes. Spreading investments across stocks, bonds, real estate, and cash — and further diversifying within each class (different sectors, issuers, maturities) — helps avoid the kind of correlated-asset risk that can make a portfolio look diversified on a statement while behaving like a single concentrated position when a sector declines. Mutual funds, ETFs, and target-date or life-cycle funds can help investors achieve this kind of broad diversification, with life-cycle funds carrying the added benefit of rebalancing automatically over time.
- Rebalance and review regularly. Whether an account is self-directed or professionally managed, periodic reviews help catch concentration before it becomes a problem and keep the portfolio aligned with an investor's actual objectives and risk tolerance.
- Understand what you own before you buy it. Researching mutual funds, ETFs, and other products—including how they're built and what they're correlated with—helps investors recognize concentration risk early enough to do something about it.
- Have an exit strategy ready. Knowing how and when to reduce a position, before market stress forces the decision, allows for a quicker, calmer transition to protect assets when conditions change.
When Concentration Risk Becomes a Legal Problem
Diversification is a basic, well-established principle of investing. When a broker or financial advisor builds — or fails to unwind — a portfolio that is overly concentrated in a single stock, sector, or illiquid product, that can amount to more than a bad investment outcome. Depending on the facts, it may violate FINRA suitability obligations, Regulation Best Interest, or a broker's fiduciary duty to the client.
A brokerage statement listing ten or fifteen different holdings can still be functionally undiversified if those holdings are all highly correlated — moving together when the sector or market segment they share runs into trouble. Recognizing that kind of hidden concentration often requires a closer look at how a portfolio was actually built and managed over time, not just how many line items appear on a statement.
If you have invested with a broker, financial adviser, or firm whose recommendations created or perpetuated concentration risk in your portfolio — and that concentration led to significant losses — please contact The Law Offices of Jonathan W. Evans & Associates online or call (818) 760-9880 for an investigation and consultation.