Concentration risk : How should you manage it?
A concentrated position simply means when your portfolio holds a significant portion of a security or a particular asset class. The risk here is the potential for a loss in value of an investment portfolio. However, if there is a significant loss then the recovery could be very difficult and unlikely in certain cases. When investing in the market, no single formula fits all investors, hence you need diversification which helps in distributing the risk across sectors in your portfolio.
Concentration risk is generally found when the market is liquid or there is a credit risk. The risk is usually calculated when you compare the liquidity of assets to their risk exposure. In a large investment portfolio switching assets immediately could be a problem. Credit risk could happen if a company or a group of debtors in the same sector default on returning the money borrowed could be risky when there is no sufficient diversification in your portfolio.
For example, sector funds do stand a big concentration risk as they only focus on a single sector. So the risk of concentration could mean serious losses on a portfolio. To protect your portfolio from these losses you need to know how to diversify. Putting all your eggs in one basket isn’t the right strategy. Diversification of investments in your portfolio would depend on your objectives, timeframe and your attitude to risk.
Some tips to manage the risk
Diversify across asset classes: If you opt for exchange-traded funds or managed funds you would be able to achieve broad diversification. Investing in one fund house or one type of sector it wouldn’t help you with diversification.
Review regularly and rebalance when needed: It is important for you to review your portfolio and if need be you can take help of a professional. Depending on how the market has performed you can periodically invest, reinvest or rejig your portfolio depending on which coincides with your investment objective. However, in case of a superannuation fund, your fund may offer an automatic rebalancing through a fund manager.
Understand the liquidity: You need to understand the liquidity of your investments if in case you may need the funds. It is important you read the offer document and understand your investment liquidity. If a large percentage of your money is in illiquid security then you need to get professional help and seek potential remedies.Access your risk and investment goals: Once you set a goal on how you want to build your wealth it would allow you to make certain investment decisions. Your risk appetite would also be a deciding factor on whether you are willing to risk the potential of negative returns to build your wealth or you’d want to go the conservative way.