We’ve all had that friend, family member, or acquaintance who goes all in on a hot stock just to get burnt. With everything lost, they’re forced to rebuild from the ashes of their savings… only to do it again! Far too many people think of the stock market as just a giant casino, with promises of great riches awaiting them once they finally hit that winning stock. Of course, there’s a ton of money to be made in the stock market—just look at Warren Buffett—but too many people don’t invest; they throw money at it.
Often, the better path is the slow and steady one, where we take calculated risks rather than foolhardy ones, and we spread that risk according to our risk tolerance with the aim of steady gains without losing our savings while we’re at it. That brings us to the core of our topic today: the importance of portfolio diversification and the role of concentration risk.
What is Concentration Risk?
Concentration risk refers to the potential impact on a portfolio when a significant portion is allocated to a single investment or a group of correlated investments, such as the tech industry or banking sector. While it might be tempting to bet big on “winners,” history is littered with examples of once-dominant companies or industries that collapsed, taking investors’ portfolios down with them. Lehman Brothers, BlackBerry, Kodak, and the dot-com bubble—to name just a few.
With fewer holdings in a portfolio, every decision carries more weight—and the pressure to get it right becomes overwhelming. Imagine investing 20% of your portfolio in a single stock versus spreading your money across a thousand companies. Just one company or industry failure can lead to a blow you may not recover from if you’re too concentrated.
Emotional attachment is another issue when it comes to concentration risk. Investors often develop a personal connection to individual stocks, especially those that have performed well in the past. This emotional bond can make it harder to sell even when red flags emerge, leading to delayed decision-making and potentially larger losses. It’s all about emotions!
Finally, let’s talk about asset allocation. Having too much concentration in a single asset class—whether bonds or equities—can be risky. For example, too much money in bonds can lead to an underperforming portfolio. Alternatively, a portfolio packed with equities and no bonds has a long way to fall if the market goes belly up. A healthy mix of stocks and bonds based on your risk appetite and investment horizon is usually the best way to go.
The Power of Diversification Through Funds
Okay, so it’s very easy to over-concentrate your portfolio. You have to worry about the industry you invest in and the location of those companies to help reduce geopolitical risk, and you want a good mix of medium and large companies. How many stocks do you actually need to buy to achieve diversification? And how difficult is it? Sounds impossible, right? That’s where index funds come in.
An index fund is an investment vehicle designed to mirror a specific market benchmark, like the S&P 500 or the total U.S. stock market. Think of it like a giant basket that holds pieces of hundreds or even thousands of companies at once. When you buy into an index fund, it’s as if you’re getting a slice of the entire market pie rather than purchasing individual pieces. These funds simply aim to track a market index – imagine taking a snapshot of a specific market (like the S&P 500) and holding all those pieces in proportion to their market value.
Index funds come in two flavors: ETFs and mutual funds. ETFs are like taxis – you can hop in and out whenever the market is open, with the price changing throughout the day. Mutual funds, on the other hand, are more like a bus – everyone gets the same price at the end of the day, regardless of when they placed their order.
The differences go beyond just trading times. ETFs often offer some interesting tax advantages because of how they’re structured. When investors sell mutual fund shares, the fund might need to sell some investments to raise cash, potentially creating taxable gains for everyone who owns the fund. ETFs, however, have a special mechanism that could help minimize these tax events.
Cost-wise, ETFs often come with lower ongoing expenses than their mutual fund cousins. While both types charge management fees, mutual funds might include additional operational costs. However, mutual funds might be more practical in certain situations – many 401(k) plans, for instance, offer mutual funds over ETFs due to their ease of automated investing, potential lack of trading fees, and NAV-based pricing.
In Conclusion
Concentration risk is one of the biggest pitfalls we see, and too many investors don’t realize how much exposure they really have until it’s too late.
Diversification isn’t about avoiding risk altogether—it’s about spreading it wisely. The right strategy depends on your financial situation, goals, and risk tolerance—because no two investors are alike.
If you’re unsure whether your portfolio is balanced or if you’re taking on unnecessary risk, let’s talk. Book a time below, and we’ll help you figure out if your investments are working for you—or against you.
