How to Avoid Concentration Risk with Your Personal Assets
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When we talk about someone’s net worth, we take into consideration all of his or her assets and liabilities. The assets can range from property, to cash, to investments, to employee stock options. Generally, the more asset types that are in a portfolio, the more diversified it is. What if your property investments make up 90% of your net worth? That’s not a well-diversified portfolio. A properly diversified portfolio needs more than just a certain number of types of assets; those assets also need to have proportionate weight.
Because investments inherently change in value over time, it’s not uncommon that their respective weights in a portfolio will fluctuate, sometimes only slightly, but other times, quite substantially. You might be thinking, but isn’t it good when an investment increases in value? The answer isn’t as simple as “yes” or “no”: when an asset holds significant weight in your portfolio, you become over-exposed to risk.
This over-exposure is called concentration risk. Concentration risk is the potential for a given investment to compromise the well-being of a portfolio.
What is concentration risk?
It’s important to understand concentration risk when developing a management strategy for your personal assets. If a single asset type accounts for a significant portion of your net worth, that can create a dangerous imbalance for your assets and financial security. An asset that weighs much more than all the others in a portfolio mix exposes you to unnecessary risk in the case that the asset’s value changes suddenly.
Concentration risk can take on many forms and degrees. For example, if you invest only in Real Estate, your concentration risk is heightened due to having exposure to only one asset class. Then, if all of those Real Estate holdings were to all be in the same country or city, the concentration risk would be made even worse by not only being invested in just one asset class but also being concentrated in a single geographical location.
Rebalancing: How to avoid concentration risk
Establishing a diversified portfolio of asset classes is a great way to avoid concentration risk, but, over time, as assets increase or decrease in value, an individual can become overexposed or underexposed to risk.
Managing a predetermined balance of various asset types over time can be tricky, as asset class values change: property values increase when housing markets are up and decrease in recessions, and employee stock option values increase when a company does well and decrease when a company goes bankrupt.
What you can do to manage your personal assets
There are steps everyone can take to minimise the chance of concentration risk.
Here is a list of ways you can run a quick check on your financial health, particularly when it comes to being over-concentrated in any one asset class:
- Have a liquid emergency fund as part of your portfolio’s asset allocation. You never know what will happen to a loved one’s health, the economy, or your refrigerator. Be prepared with 3-6 months of living expenses ready to use in a moment’s notice.
- Check your balance of assets periodically, whether that’s twice a year, or every quarter. Create a reminder system to assess your assets’ values, and be prepared to rebalance your portfolio as your assets and net worth change over time.
- Have employee stock options? Diversify away any concentration risk by systematically selling company stock once it becomes vested. Vesting schedules differ from company to company, so try to set reminders based on your vesting schedule to check if a new portion of stock has become available for sale.
- If you sell an overweight investment, invest it in other places to create even more diversification, as long as your emergency fund is topped off.