Let's say you start a portfolio with 10 stocks, investing $10,000 in each name. At the beginning, your risk profile is fairly balanced. Immediately after investing, the stocks will start to chart different courses. What tends to happen is that enough though the average annual return of the market at large is 9-10 percent per year, the winners win in a far greater magnitude than most investors realize, and the losers lose far more money than the naive expectation would be. Stock returns are highly, highly skewed towards both big winners and big losers.
Investors collectively make the mistake of plowing money into losing stocks and selling their winners, costing them billions of dollars per year. The academic name for this phenomenon is the disposition effect.
Inferring from the broader statistics, of your 10 stock portfolio, the odds are that you'll have a couple of big winners, a couple of big losers, and the rest of the stocks will return between 0-10 percent per year. As such, your portfolio value will rapidly concentrate in the shares of your winners, and the problem will tend to get worse over time. This is both an opportunity and a problem from a risk management standpoint.
This mechanism of concentration poses a few issues for investors.
1. If you don't let your winners run, your returns will drift towards the median equity return of about 5 percent per year (this is notably lower than the mean return of 9-10 percent). Studies show that <5 percent is indeed about the average return for investors. This is unacceptable because if you can't at least get close to the return of the market, then you're wasting your time and money.
2. If you allow 1 or 2 stocks to take over 40-50 percent of your portfolio, then almost all of your risk is concentrated in a couple of stocks. This dramatically increases the risk profile/standard deviation of your portfolio. Remember that Apple (AAPL) drew down over 80 percent in the 2000s.
One of the most successful stocks in history has experienced bear markets every couple of years on average.
Here's the same graph for Amazon (AMZN).
Amazon is even worse– it didn't recover its bubble valuation for 10 years.
3. If you have equities and bonds in your portfolio, the equities will take over your portfolio over time due to their higher return vs. bonds. With my calculations showing that equities are expected to return about 5 percent higher than corporate bonds over time, constantly selling stocks to buy bonds is going to be an expensive way to manage risk. Short duration bonds are a lousy hedge for equity risk, plus equity investors who badly mistime the market still typically end up with significantly more money over a 20-year period historically. You can reinvest your dividends and you'll grow an income stream you can count on later.
How Do You Manage Concentration Risk?
1. A lot of investors are either in the stock picking camp or the ETF camp. I think that a more sensible approach to limit the concentration of risk is to do both. For example, you can have an ETF portfolio as a foundation and then pick a couple of stocks you love on top of that (maybe 80 percent of your portfolio goes into ETFs and you put 10 percent each in a couple of stocks you believe in). By only investing in your best ideas, you maximize your chances of beating the market and minimize your chances of materially underperforming. If you pick stocks well, your winners will still tend to take over your portfolio, but you won't be burning the match at both ends by piling money into losers, because index funds automatically allow winners to run. If you do this properly, it allows you to get a higher return for less risk.
2. You will make more money if you let your winners run, but you don't want to let your portfolio be one or two stocks. That's why I recommend only allowing yourself start an individual stock position at 10 percent of the net liquidation value of your portfolio, and systematically diversifying money into ETFs if a position gets over 35 percent. I backtested this with the internet bubble and bitcoin bubble, and it allowed you to ride the gains without losing all your money on the burst. This is a fair balance between falling victim to the disposition effect and failing to manage concentration risk. And I know most of my readers are smarter than this, but do not use margin or leverage if you're going to concentrate risk in a few stocks. Backtests show that you will almost certainly lose.
3. If your portfolio is split between stocks and bonds, consider using leverage on the investment grade bond portion of your portfolio. This can be accomplished via the futures market or through funds like PIMCO funds (PIMIX). This helps you get a higher return, diversifies the risk profile of your portfolio, and helps prevent equities from taking over your portfolio. If you're not comfortable with leverage, consider at least investing in longer duration bonds, especially Treasuries and AAA corporate bonds. These tend to catch a bid when equities drop. This reduces your risk.
Additionally, if you're comfortable allowing your portfolio to become concentrated in a few stocks, you might want to consider combining leverage with true diversification and spread of risk as an alternative. The returns are just as good, and the risk is actually lower.
This is true both in theoretical finance and in practice. Leverage on a truly diversified portfolio of stocks, Treasuries, corporate bonds, mortgage-backed securities, and gold is easier to manage than concentration risk.
To this point, I was able to design a portfolio that gets about a 20-21 percent annual return with roughly a 10 percent standard deviation using the principles that I write about like leveraged rebalancing, diversification, risk parity, volatility targeting, and negative correlation.
Concentration risk is something that you need to manage if you have a stock portfolio. Your winning stocks are going to take over your portfolio. Therefore, you need to know ahead of time what your strategy is for managing the risk of concentration. Let your winners run, but don't let them take up so much space that your portfolio is all Apple and Amazon. Picking individual stocks is fine, but consider limiting your picks to your best couple of ideas and replacing your marginal ideas with ETF index funds. You'll make more money this way if you're right, and you can stop telling yourself that you're diversified because you own 20 stocks when you know from watching your portfolio that it's not true. Using ETFs rather than buying stocks you feel lukewarm about reduces your commissions and taxes, increases your returns, and helps you manage risk better. It's a win all around.