Risk ManagementMar 30, 20265 Min
Understanding Concentration Risk in Global Portfolios
One of the key benefits of participating in the stock market is that it offers you access to different types of instruments and asset classes, like stocks, bonds, ETFs, and commodities. As an investor, it should always be your strategy to spread your investment across all these asset classes. Concentration in one security or asset class may increase investment risk.
This is when the concentration risk arises, as your portfolio is not diversified. This increases your exposure to risk and losses. In this blog, we will understand what concentration risk is and how you can manage it for your global portfolios.
What is Concentration Risk?
Concentration risk arises when your portfolio is not diversified and leans more towards a single security or asset of classes. Simply put, concentration occurs when you have a significant percentage of your investments in a small number of stocks, industries, or markets. It exists even in a global portfolio. A few examples of the concentration risks are:
- Overweighting a single stock: A significant percentage of your funds is allocated more towards a single company, like Tesla or Reliance Industries. If the stock goes down, your portfolio will incur more losses.
- Overweighting a sector: If not a single stock, your portfolio is invested more towards a specific sector, like IT or healthcare. The risk is higher here since the companies within the same sector react coherently to market trends and news.
- Concentrating on a country or region: Another example is when you concentrate on a single market, like emerging market equities, and that puts you at risk of local economic or political risks.
The concentration risk is not necessarily bad. Investors make concentrated positions by choice, either through belief or plan. However, unmanaged concentration can increase losses during market downturns, sector corrections, or geopolitical events.
Concentration Risk in Global Portfolios
The concentration risk does not only manifest itself in single stock bets, but it may also manifest itself in any global portfolio, even one that appears to be diversified in terms of countries, sectors, and asset classes.
Market-level Examples
1. US Technology Dominance
Many global indices and ETFs are overweighted in US technology stocks such as Apple and Microsoft. A decline in this industry may have a disproportionate effect on portfolios, even when they are internationally exposed.
2. Emerging Market Exposure
Emerging markets are volatile because of economic, political, or currency risks. The concentration on a single country like India, Japan, or Brazil can increase losses in case of local declines, necessitating the management of the risk.
3. Currency Risk
Investing in the global stock markets significantly influences currency fluctuations. Overvaluing one currency, such as the US dollar, can also have an impact on returns if that currency depreciates against your home currency.
Portfolio-level Examples
4. Overlapping Holdings between Funds
There is a possibility of holding several global funds or ETFs that hold the same top companies, which may inadvertently concentrate risk. For example, your portfolio might seem diversified with three funds, but when all of them have Apple, Microsoft, and Amazon as their top holdings, your portfolio is overweighted in those stocks.
5. Country- or Sector-heavy ETFs
Even a global portfolio that looks diversified can carry hidden concentration risk. This often occurs when a large portion is invested in a single sector-focused ETF or a country-specific fund. While multiple funds may give the appearance of diversification, overlapping top holdings or regional biases can cause the portfolio to move in tandem with one sector or market.
6. Hidden Concentration
A portfolio that is diversified in several markets and funds may have concealed concentration. The portfolio may be less diversified than it is because of overlapping holdings, dominance in the sector, or regional bias. It is important to identify these concealed exposures in order to control risk and safeguard long-term returns.
Effect of Concentration Risk on Portfolio
Concentration risk can have a major influence on the behavior of a portfolio, particularly in times of market stress. Its impacts are likely to manifest themselves in volatility, drawdowns, and the entire idea of diversification itself.
1. Higher Volatility in Portfolio Returns
If a portfolio is concentrated on a small number of assets, overall performance is dominated by the movements in the particular positions. The decline of a single stock, industry, or market can cause the whole portfolio to move drastically.
Returns in a diversified portfolio become more volatile than in a broadly diversified one. Concentrated portfolios can have more up and down swings, since they do not have the dampening effect of diversification of risk among many unrelated assets.
2. Potential for Larger Drawdowns
Drawdown refers to the fall in the portfolio value between a peak and a trough, and concentration risk increases the losses significantly. For example, growth-oriented or tech-heavy portfolios experienced significant declines in the recent market downturns.
In 2022, the growth stock portfolios and tech-oriented ETFs declined significantly. It implies that when a concentrated component performs poorly, a significant chunk of the overall portfolio value can be lost before the recovery process can even start.
3. Less Effective Diversification
Diversification helps spread risk in case poor performance in one area does not bring down the entire portfolio. However, when the weightings are concentrated, this cushion is diluted or completely lost. The benefit of diversification can be undone by having several funds that have a high degree of overlap in the top holdings, or by having a single region or sector that takes up a significant portion of total assets.
4. Practical and Historical Examples
A hypothetical concentrated position that is declining by 30% can result in a 15% loss in the portfolio when that one asset represents half the portfolio. Even those who believed they were diversified by holding multiple tech names (e.g., the 2022 tech sell-off) made huge losses since the whole market moved in one direction.
How to Reduce the Concentration Risk
After determining the concentration risk, the second step is to manage it to protect your international portfolio. Here is how you can reduce the concentration risk:
1. Diversify by Sectors, Geographies, and Asset Classes
The simplest way of eliminating concentration risk is by diversifying investments in various sectors, countries, and asset classes. Avoid overinvesting in one stock, sector, or area. And add equities, bonds, and other asset classes to even out portfolio volatility.
2. Apply Broad-Market Index Funds and ETFs
Broad-market funds provide exposure to hundreds or thousands of stocks or bonds, which inherently dilutes the effects of any one holding. Index ETFs can help diversify across companies, sectors, and markets globally or regionally.
3. Do not Over-Allocate to Individual Funds or Best Holdings
Even diversified funds can cause hidden concentration when your portfolio concentrates on the best holdings. You must avoid exposing your portfolio to one fund or the biggest stocks in that fund. Overlaps in the monitoring of various investments to ensure that there is no unintentional concentration.
4. Rebalance Portfolio Regularly
With time, market movements can lead to some positions becoming disproportionate. Rebalancing helps you realign your planned allocations and ensure that no one asset or sector takes over your portfolio. Rebalancing also strengthens disciplined risk management without depending on market timing.
5. Consider Hedging or Alternative Assets
In some instances, high conviction or strategic objectives make concentrated exposures inevitable. Hedging with options, inverse ETFs, or currency instruments can reduce risk. Alternative assets like real estate, commodities, or private equity can provide uncorrelated exposure to diversify overall portfolio risk.
Through these strategies, you can actively control the concentration risk and still be involved in the growth of the global markets. The aim is to have a balanced risk exposure, smoother returns, and resistance to sectoral, regional, or stock-specific shocks. Diversification does not eliminate investment risk or guarantee returns.
How to Balance Concentration Risk and Portfolio Goals
Here are the steps you can follow to balance concentration risk and portfolio goals:
- Determine your risk tolerance: Understand the degree of volatility or loss you can take without concentrated positions.
- Align with your time horizon: Long-term investors may be able to bear greater concentration with research support, whereas short-term objectives demand greater diversification.
- Base decisions on research and conviction: Only overweight sectors, regions, or stocks when you have strong data or insights to support it.
- Keep concentrated positions small: Avoid allowing one asset or industry to take control of your portfolio by limiting it.
- Monitor and modify: Keep track of the changing nature of concentrated positions over time and re-adjust as necessary to keep in line with your objectives.
Conclusion
Even in portfolios that are well diversified, there is concentration risk. Without awareness, exposure to sectors, countries, or the largest holdings can increase losses in market declines, reducing the impact of diversification.
The good thing is that concentration risk can be kept at bay through active monitoring and careful portfolio management. And the most effective way to manage a portfolio is with global diversification. Dealing.com gives you access to 30k+ investment opportunities across 10+ global exchanges. Investors should consult professional advisors and consider their risk tolerance before making investment decisions. Global diversification may help manage, but does not eliminate, portfolio risk.
Disclaimer: This content is for educational purposes only and does not constitute investment advice, personal recommendations, or a solicitation to buy or sell financial instruments. All investments involve risk, including potential loss of capital. Investors should consult professional financial advisors and consider their personal circumstances before making any investment decision.
