There are many approaches one can take towards investing. And many of them can be right or wrong – depending upon a range of factors. At the same time, different investment approaches have different risk associated with them. One of the risks associated with investing is concentration risk.
Concentration risk is the risk which an investor faces while investing in only few assets and not diversifying enough. It can be concentration in a single asset class (e.g. – all equities or real estate) or single or few investments within one asset class (e.g. – buying just 2 stocks for entire portfolio!)
If everything goes well, this concentration can be very good for you. But it requires things going wonderfully well for that asset class and your specific investments.
(In case you can predict that and benefit, this post is not of any value to you)
But, as you think of placing concentrated bets … are you aware of the risk?
What if the asset class/ investment you have been bullish upon, doesn’t do well?
Here are some ways the concentration risk while investing can play out.
- Putting all your investment in equities may yield good results when stock markets are doing good (they have, mostly, over long time horizon). But what if portfolio sees a 2008 like crash? Hopefully markets will recover later, but what if you needed to withdraw money around the time of crash (And you have no “relatively safe” debt instrument to fall back upon!) (Related – Capital protection versus capital growth)
- Had you bet on stocks like Titan, HDFC, Britannia, Eicher etc. a decade back, you may have generated good returns. More so, if your portfolio only has couple of these “awesome” stocks! But what if you had a concentrated portfolio with stocks like Suzlon Energy or Reliance Communication (Remember – they were considered great stocks till few years back!). While having a diversified portfolio is no guarantee against losses, you can reduce probability of your portfolio turning into a collection of wealth destroyers!
- On the other hand of spectrum there are conservative investors who park most of their (or entire?) net worth in fixed deposits. While it is as close to risk-free investment as it gets, this poses another risk – the risk of you not generating inflation adjusted returns in long run! (Related – The risk of not investing in equities). Some conservative investors may park money in “risk-free” corporate bonds. In case of default, their entire capital is at risk.
- Real estate – While it may or may not be a good investment (in most cases, probably not!), many people in India have real estate as the biggest chunk of their investment portfolio. In case of little or no appreciation (or negative returns), there is likelihood that you’ll be stuck with it – till you find a buyer for this illiquid asset, who is ready to pay a good price!
(Note- This is just a partial list and the scenarios related to concentration risk in investing can play out in many different ways.)
I am not an expert in predicting what will happen in future and how things will play out. Nor can anyone else, including experts, do anything more than making a educated guess. Many of them may be true. But no one, including the most powerful people in the world, control all the factors!
Hence, for the lesser mortals, it may be good to diversify your portfolio. (Especially if you can’t afford to lose a lot of money.)
Being optimistic about one asset class/ stock etc. is one thing and this can yield good results. But if something goes wrong, some cushion can definitely help.
Putting all your eggs in same basket may save logistics cost, but if something untoward happens, then …