In this episode of ThimbleberryU, Jon Gay and Amy Walls discuss the risks of having a highly concentrated portfolio. Amy defines a highly concentrated portfolio as one where a single asset or a small group of assets constitutes 10% or more of the portfolio’s total value. This lack of diversification can increase risk significantly, as the portfolio’s performance hinges on those few investments.
Amy explains that increased volatility is a major risk factor. A portfolio with fewer assets is more susceptible to large swings in value based on the performance of those assets. For instance, if a single asset makes up 25% of the portfolio and its value drops significantly, the entire portfolio suffers. This risk is compounded if the concentrated asset belongs to a single company or industry, which can be affected by negative news, regulatory changes, or industry-specific challenges.
Jag and Amy also explore the emotional stress associated with a concentrated portfolio. Significant fluctuations can lead to stress, resulting in impulsive decision-making, such as selling low during downturns. Amy highlights the importance of diversification in spreading risk and reducing the impact of any single investment’s poor performance. Without diversification, investors are essentially putting all their eggs in one basket, which can be dangerous.
To assess if their portfolio concentration is acceptable, Amy suggests investors ask themselves several questions. These include evaluating their financial and emotional ability to handle a significant loss, understanding their level of diversification, considering their time horizon for needing the money, and determining their stress tolerance for market fluctuations. Investors should also reflect on their understanding of the investment and its risks, how it aligns with their long-term financial goals, and their exit strategy if things don’t go as planned.
Behavioral finance plays a crucial role in investment decisions. Amy advises listeners to consider their reaction to market volatility, potential overconfidence in investment decisions, and biases such as anchoring, confirmation, and recency bias. It's essential to recognize tendencies to hold onto losing investments or be influenced by herd behavior. Additionally, Amy emphasizes the importance of simplifying decision-making processes and understanding how personal experiences influence behavior.
If investors decide their portfolio is too concentrated, Amy recommends several steps. These include immediate or gradual diversification, using tax-advantaged accounts to minimize tax impacts, considering exchange funds to pool concentrated stocks with other investors, employing hedging strategies, making charitable donations of concentrated stock, and seeking professional guidance.
In conclusion, Jon and Amy stress the importance of regularly reviewing portfolios and reassessing risk tolerance. Each individual’s situation is different, and risk tolerance can change over time. Staying flexible, open-minded, and informed is crucial for managing investment risks effectively.
ThimbleberryU 116 - Is Your Portfolio Too Concentrated
Speakers: Jon Gay & Amy Walls.
[Music Playing]
Jon Gay (00:03):
Welcome back to ThimbleberryU, I'm Jon “Jag” Gay with Amy Walls of Thimbleberry Financial. Amy, today we're talking about understanding portfolio risks.
Amy Walls (00:10):
Yes.
Jon Gay (00:12):
One of the biggest risks is a highly concentrated portfolio. What does that term even mean before we start?
Amy Walls (00:17):
So, a highly concentrated portfolio is one where a single asset or a small group of assets makes up 10% or more of the portfolio's total value. That's a lack of diversification and that lack of diversification can significantly increase risk because the portfolio's performance is now heavily dependent on those few investments.
And so, what that means is if those investments perform poorly, the entire portfolio can suffer significantly.
Jon Gay (00:43):
Okay, let's dig in a little bit deeper. It's risky, it's dangerous. What are some specific reasons as to why a highly concentrated portfolio can be so risky?
Amy Walls (00:51):
Yeah, there's several reasons. First, increased volatility. Volatility is ups and downs. We worry more about downs than ups. But with fewer assets, that portfolio is more susceptible to big swings in value based on performance of those assets.
Because if you've got one holding that's 25% of a portfolio, if it's swings up, great, the portfolio goes up a lot. If it swings down a lot, that portfolio value's going to go down because it makes up so much of the portfolio.
Now, let's say that this is all in one company, it's a concentrated risk. So, any negative news about that company, any performance issues with that company can severely impact the portfolio. And that can be amplified if there's industry challenges. It's not just company-specific, but maybe it's a single tech company, and right now, tech is struggling.
So, now, we've got an industry-specific challenge, and that could be coupled with a company-specific challenge too.
Jon Gay (01:56):
We hit on that a lot during our six-part series on tech professionals for sure.
Amy Walls (02:00):
Yep. It could be regulatory changes. What if this company gets hit with a lawsuit around being a monopoly? Or just simple management issues, those come up.
Jon Gay (02:12):
Yep, for sure.
Amy Walls (02:14):
General lack of diversification is another. Diversification spreads risk around different assets, and it reduces the impact of any single investment's poor performance. It mitigates risk. And so, without it, without that diversification, you're putting all your eggs in one basket and that can be dangerous.
And then lastly, it's not a number situation, but it's emotional stress. It's a psychological piece. Significant fluctuations lead to stress, and they can also contribute to impulsive decision-making. We've talked about decision fatigue. Stress is part of that. We make bad decisions when/or we can make bad decisions when under that kind of stress.
So, if you're an investor feeling that stress, you might be compelled to make a hasty and potentially bad decision during a downturn, which might result in selling when something's low and buying when something's high, and thus, negatively impacting your long-term returns.
Jon Gay (03:19):
The opposite of buy low and sell high, absolutely. And I know behavioral finance is a big thing for you. And another big thing that we've talked about in the podcast all the time is that every individual situation is different. So, if someone has a highly concentrated portfolio, what basic questions should they ask to assess if they're okay with the risk they're taking?
Amy Walls (03:36):
Some of these questions as I throw them out may kind of sound similar, but to different people, they're going to mean different things.
One, if I lost this money, am I okay? Am I okay financially? Am I okay emotionally? So, really, can I afford to lose a significant portion or even all of the money that I have invested without jeopardizing my security?
How would a significant loss impact my lifestyle? That's important because if you're going to be uncomfortable, this might not be the right choice. Do I have enough diversification in my overall financial portfolio? Meaning, maybe I am very diversified elsewhere and so I'm willing to take on the risk of this one asset.
Jon Gay (04:21):
That makes sense.
Amy Walls (04:23):
But I've weighed the pros and cons there. What's my time horizon for needing this money? If I anticipate needing access to it, how is that going to play out? Do I have time to recover if it goes down? What am I going to do if it goes down and is down when I actually intended to use the money?
Here's a nice one: how much stress am I willing to endure due to market fluctuations?
Jon Gay (04:50):
Different for everybody.
Amy Walls (04:52):
Absolutely. I like this one too: do I have a clear understanding of the investment and its risks? Now, I think everybody is normally going to say yes before they go into an investment. Of course, I understand it, but if we step away from investments, I can't tell you how many times I'll like be talking to someone about something. Maybe it's sales, maybe it's new software I'm considering.
I dig into it, I ask questions, and then I say, “Okay, so here's my recap, I understand, is there anything else I need to know?” The answer is, “Nope, you've got it.” And then down the road I find out there's some other big piece that I didn't know about. So, do I truly understand it and know about it?
Jon Gay (05:29):
Speaks the importance of working with a financial professional for sure.
Amy Walls (05:32):
Absolutely. How does this investment align with my long-term financial goals? What's my exit strategy if this doesn't go the way I want it to?
Jon Gay (05:42):
Plan B or C, D and E if you need it.
Amy Walls (05:46):
Am I receiving professional advice on this? And what does that professional say and why?
Jon Gay (05:50):
That's so important.
Amy Walls (05:52):
Are there any tax implications I need to consider? And lastly, I'll say how does this investment and my willingness to do it or not do it affect my ability to sleep at night?
Jon Gay (06:05):
We're kind of veering into that area of behavioral finance that we've talked about so many times before in the podcast. Related to that, specifically, what are some behavioral questions our listeners should consider in this situation?
Amy Walls (06:17):
In your last question, I probably hit on a couple of them. Like how do I react to market volatility, types of things. But I think there's a couple that could be new. One, do I tend to be overconfident in my investment decisions?
Jon Gay (06:31):
Yeah, bias.
Amy Walls (06:32):
Yep, what biases do I have? I think looking at that anchoring bias, confirmation bias, status quo bias, recency bias — those are all biases that could play a role. Do I have a tendency to hold onto losing investments? Sometimes people do that just to not be wrong.
Jon Gay (06:55):
Yeah.
Amy Walls (06:56):
Do I have a need to be right? And so, I'm going to hold onto something no matter what.
Jon Gay (07:00):
And go down with the ship.
Amy Walls (07:02):
Yep. How much does herd behavior influence my investment choices? This is what I hear a lot, especially when people are in the office: “Hey, we were standing around the water cooler getting coffee and my friend was talking to me about X, Y, and Z investment and everybody else was on board with it, why am I not in it?”
Jon Gay (07:21):
And that's to say nothing of the meme stocks, which is a whole other topic.
Amy Walls (07:24):
Oh yeah, absolutely. This one I think is important: I am a big fan of simplification, but how do I handle complexity in decision-making? Because if complexity throws you for a loop, causes you to freeze, getting heavily concentrated or staying heavily concentrated just increased complexity.
Jon Gay (07:45):
Fair enough.
Amy Walls (07:46):
Lastly, how do personal experiences influence my behavior? So, I think I want to expand on this one a little bit.
We have things in our past that influence our future. Things we do now — I'll jump away from this for a second, but one of the things I regularly talk to clients about is, if they're looking to make an investment, let's say in a brokerage account, they've got extra money sitting around, do they want to do it as a lump sum or do they want to dollar cost average, meaning, like, invest each month for a period of time?
People's behavior comes into play when I make a recommendation around that. Long term lump sum investing tends to win. Statistically it does. But for certain people, if they do that and the market drops the next day, it will keep them from investing and doing the right thing in the future. So, we have to pay attention to that.
Jon Gay (08:39):
Lot of introspection needed as we've been going through today, Amy. And so, once you've kind of taken these mental checks, what steps can someone take if they decide that their highly concentrated portfolio is too risky for their comfort level?
Amy Walls (08:53):
Well, it could be immediate or gradual diversification. Same thing as that lump sum versus dollar cost averaging we just talked about. How do you make that move using tax advantaged accounts just to minimize tax impacts if possible? Maybe you're considering being heavily concentrated — where do you want to do that might be the question.
Exchange funds: this would allow you to pool your concentrated stock with other investors to create a more diversified portfolio without immediately triggering capital gains.
Jon Gay (09:25):
Okay, good to know.
Amy Walls (09:26):
There are hedging strategies. So, I won’t go into details there. Making charitable donations. Maybe if you're heavily concentrated, you're charitably inclined, maybe giving some of that stock away to charity is the perfect answer.
And overall, with all of these strategies, getting guidance from a professional, not from your friends around the water cooler or the coffee pot.
Jon Gay (09:48):
Or the group chat, to make a modern reference as well.
Amy Walls (09:52):
Or Reddit.
Jon Gay (09:53):
Oh gosh, no. Let's not even go there. All these really are excellent strategies, Amy. Before we wrap up, anything else you want to add to tie this all together?
Amy Walls (10:02):
These were all ideas, but I think it's important to remember that it's important to regularly review your portfolio and assess your risk tolerance, not the other people around you’s risk tolerance.
And that it's okay that your risk tolerance changes over time. One stage in life, it can be one thing, and at a later stage, it can be something else. And that doesn't necessarily mean that it goes from high to low. It could go from low to high based on different factors. So, staying flexible, staying open-minded and informed is really important.
Jon Gay (10:39):
So, to sum it up, you don't want to be overly concentrated in your portfolio, but overly concentrated means different things to different people, depending on their risk tolerance and so many other factors. Every individual situation is different, as we say, almost every time on the podcast, Amy.
If someone wants to come talk to you and the team at Thimbleberry about their individual situation, how do they best find you?
Amy Walls (10:59):
They can find us online at thimbleberryfinancial.com or give us a call at 503-610-6510.
[Music playing]
Jon Gay (11:07):
Great stuff, Amy. We'll talk again in a couple weeks.
Amy Walls (11:09):
Sounds great.
Jon Gay (11:10):
Securities offered through registered representatives of Cambridge Investment Research, Inc, a broker-dealer member of FINRA/SIPC. Advisory services through Cambridge Investment Research Advisors, Inc, a registered investment advisor. Cambridge and Thimbleberry Financial are not affiliated.
Discussions in this show should not be construed as specific recommendations or investment advice. Always consult with your investment professional before making important investment decisions.
Securities offered through registered representatives of Cambridge Investment Research, Inc, a broker-dealer member of FINRA/SIPC. Advisory services through Cambridge Investment Research Advisors, Inc, a registered investment advisor. Cambridge and Thimbleberry Financial are not affiliated.