Often, the key to mitigating risk within your investment portfolio is to have a diversified approach. But what exactly is a diversified portfolio? Well, the specific answer is different for each person, but the general sentiment is to avoid having too much of your portfolio concentrated in one particular area. Reason being, having a highly concentrated portfolio opens you up to much greater risk. After all, if something negative were to happen that disproportionately affects that particular company or sector you’re concentrated in, you could see a meaningful decline in your portfolio that other holdings couldn’t likely make up for. This relates to our recent articles on knowing what you own and why you own it, and not taking any single risk which on its own could ruin investments results for your entire portfolio for the year.
Spotting Concentration
Anyone who has stock-based compensation is likely to have some level of concentration in their investment portfolios – not only in their employer stock, but often at the sector level as well.
This is especially likely to be the case for people who happen to work in large influential sectors, such as tech. Why? Because if you work in a large and influential industry, your industry makes up a considerable part of the economy (and therefore the stock market as well). As a result, even if you invested only in index funds or ETF’s beyond your company stock, you can easily develop a high concentration given that tech makes up a large portion of those funds.
Furthermore, if you and your firm are doing well, in all likelihood you will continue to receive new stock grants from your employer. That means that whatever your situation is today, your portfolio concentration will continue to increase unless you take action to re-allocate your assets periodically.
Why is this an issue?
Portfolio concentration can be an important issue because you don’t want a majority of your wealth directly tied to a single company – especially one which also happens to be the source of all your income. If you’re highly concentrated in just your employer’s stock, then if something were to happen to that company, you’d risk taking a hit not only in your portfolio, but also potentially in your paycheck.
Even if you’re concentrated within a single sector (rather than just one company), that can still pose substantial risk. For example, if the tech industry were to see new regulations (which is certainly possible given recent privacy concerns), that could affect the stock price of many companies across the sector. Recently, some large tech firms have openly invited regulation, which may be an indication that they view regulation as likely and hope to have a seat at the table.
So if that particular sector makes up a meaningful portion of your portfolio, you could see an outsized impact of potential regulations on your own portfolio.
Sector classifications aren’t always obvious
You may also be surprised to learn that not all firms are classified in the sector that you would think they are. Why? It’s because they are classified based on the product they sell and how they deliver it to the customer (not the professional background or function of their employees).
Let’s look at a popular fund: iShares S&P 500 Growth ETF (IVW). Within this fund (as of 5/13/19), Information Technology makes up 25.9%, with the next closest being Healthcare at 16.6% and Communication coming in at 14.5%.
What you may be surprised, or even shocked, to find out is that the 25.9% of the portfolio that is tech doesn’t even include Alphabet (Google) or Facebook, which are classified as Communication, Amazon, which is classified as Consumer Discretionary, or even Netflix. (And as you can imagine, these large companies are quite substantial making up 16.1% of the fund) Also surprisingly, MasterCard is actually considered to be part of Information Technology rather than Financials. Overall, these large names we think of as “tech” in combination with what is classified as Information Technology account for 42.0% of the fund.
So what does this tell us? It means that understanding the degree to which your portfolio is concentrated can’t simply be evaluated by looking at the relative weight of various sectors within a fund. Truly understanding portfolio concentration requires a more in-depth analysis that a trained financial advisor can provide.
Think your portfolio might be “overweight” in a particular industry or two? Contact Paceline and ask for a free, no-obligation Portfolio Second Opinion today.
This blog was written by Jeremy Bohne, Principal & Founder of Paceline Wealth Management. Paceline is a fee-only investment advisor serving clients in the Boston area, and on a remote basis throughout the country. Paceline specializes in helping tech and biotech executives, physicians, and those seeking financial planning services.