In most endeavors, concentration is helpful, but that may not be the case when it comes to investing. In fact, if your portfolio contains too high a concentration of a single investment, you could run into trouble. Fortunately, it’s not hard to recognize the signs of “overconcentration” — and once you do, you can take steps to correct it.
How can you know if you own too much of an investment? Everyone’s situation is different, but, in general, it’s a good idea to limit any single investment, such as a stock, to no more than five percent of your total portfolio value, although you can make an exception for a mutual fund, which, by its nature, is already somewhat diversified in that it owns a variety of stocks or bonds or a combination of the two.
Why is it risky to have a single stock take up a sizable amount of your portfolio?
The value of that stock can fluctuate significantly in any given year — from big gains to big losses.
Even worse, the value of an individual stock may not fluctuate, but just collapse. However, the more stocks you own, the less of an impact any one stock can have on your portfolio’s overall performance. In fact, by owning at least 25 stocks, representing a variety of industries, you can help lower your level of risk.
And the same principle applies to fixed-income investments such as bonds. If all your fixed-income assets are tied up in one bond, or even a few bonds issued by companies belonging to the same industry, you could be taking on too much risk. Try to avoid having any single bond take up more than five percent of your portfolio’s value. Instead, spread your dollars among a variety of investment-grade corporate bonds, representing different industries, along with government bonds. You can also increase your diversification by building a bond “ladder” comprising bonds of different maturities.
Of course, even if you understand why overconcentration can be risky, you may find it hard to reduce your stake in an investment because you think the investment’s prospects are so good that you need to own as much of it as possible. Or perhaps you’ve inherited some shares from a family member and feel an emotional connection. Or you may even be afraid that if you sell some shares, you could face some capital gains taxes.
Still, none of these reasons should keep you from reducing your exposure to a single investment and then using the proceeds to help diversify your portfolio. While diversification, by itself, cannot guarantee a profit or protect against a loss, it can help you reduce your portfolio’s volatility. So, look for opportunities to diversify your holdings.
Try to build an investment mix containing stocks, bonds, mutual funds, and Guaranteed Investment Certificates (GICs)— and then try to diversify within each category. To achieve this diversification, you may want to work with a financial advisor — someone who knows your goals, risk tolerance and time horizon.
In your day-to-day life, you’ll want to concentrate on work, relationships and hobbies. But when it comes to investments, you’ll probably find it helpful to “un-concentrate” a bit.
Deborah Leahy is an Investment Advisor with Edward Jones, Member Canadian Investor Protection Fund.