Don’t Keep All Your Eggs in One Basket

All it takes is just one stock to go to the moon, and that’s it, you’re set for life, right? Well, if it were only that simple. You see, concentrated investing, or keeping your eggs in one basket, seems to work until it doesn’t.

Now, make no mistake, concentrated investing isn’t all that bad. In fact, notable investor Warren Buffett is known to have made lots of money decade after decade because he takes big bets. 

Even so, concentrated investing isn’t for everyone.

In fact, if you were to personally ask the Oracle of Omaha for investment advice, he’d likely tell you to buy a diversified basket of stocks that tracks the S&P 500 index and simply hold on to your investments for the long haul!

And why would a sage investor give such seemingly conflicted advice?

Well, that’s because Buffett knows that concentrated investing cuts both ways. You see, on the one hand, you could score big under the right circumstances or find yourself desperately holding onto a failing position that wipes away your life savings when fate turns against you.

Indeed, whether you’ve intentionally placed all your eggs in one basket or are simply trying to figure out what to do with your restricted stock or stock options, then having a plan is essential to preventing unfavorable outcomes. 

And this approach starts with checking for concentrated holdings, assessing your risk tolerance to manage such a position, and then understanding how to rebalance away or hedge risk when necessary.

Understanding Concentrated Investment Positions

So then, how can you tell if you’re holding on to a concentrated position in your portfolio or otherwise? Well, there are several straightforward methods to figure this out.

The first approach involves evaluating your portfolio’s asset allocation. And, as you’ll likely recall, your asset allocation refers to the mix of stocks and bonds, US and International holdings you might hold in your investment portfolio.

Now, a portfolio heavily weighted towards a single investment or a given sector or industry is typically indicative of a concentrated position. For example, a general rule of thumb is that if more than 20% of your portfolio is allocated to one stock or sector, then that’s likely considered a concentrated investment.

Now, this sort of concentration typically happens when you have restricted stock units (RSUs) that vest, and you haven’t decided what to do with your equity, so you just let it sit in your employer’s stock plan account. Or, it can happen when you decide to exercise and hold your stock options but don’t have a strategy in place for your equity now that you own it.

Now, another method for evaluating whether or not you have a concentrated investment position involves reviewing your exposure to a single asset or sector relative to a benchmark index. 

And, what are we talking about here?

Well, let’s say your portfolio has 30% invested in the tech sector while your equity benchmark has a 20% weighting in the sector itself. In this situation, you’re likely to find yourself with a concentrated position from the perspective of owning more of a sector than you would otherwise like.

And finally, when it comes to determining whether you have a concentrated investment position, you should look at your holdings from the perspective of a worst-case scenario. For example, heading into the Global Financial Crisis, many employees of Wachovia Bank had their retirement savings stored up in company stock, which ultimately led to an unfortunate outcome. 

That’s because, when the bank failed, the value of their holdings was effectively wiped out, which canceled the retirement plans of many of the bank’s former employees. So then, the moral of the story here is that if the failure of a single investment would lead to a significant loss that would severely affect your future financial plans, then you likely have a concentrated position.

Evaluating Your Risk Tolerance for Concentrated Investments

Alright, so now that you understand what it means to have a concentrated investment holding, the big question now is, “do you have what it takes to hold on to that concentrated position for the long-haul?”

And this question is so essential because, as you likely very well know, the road of investing is long and winding, with pitfalls and windfalls alike. It’s like a journey where your risk appetite can significantly influence the trajectory and the destination of your investment returns. 

And so, what do we mean here by risk tolerance?

Well, to be clear, risk tolerance refers to your ability and willingness to bear losses in exchange for potential gains, especially when a large portion of your net worth is potentially ebbing and flowing with the whims of the markets.

So then, for those of you out there considering or already maintaining concentrated positions, it’s essential to have a deep understanding of not only your concentrated holdings, but also of how these investments are affected by market trends, narratives, and principles alike.

And why’s that?

Well, it’s one thing to know everything about your company stock. But to understand what Mr. Market might also think is a powerful money management skill. Indeed, financial acumen, paired with a disciplined approach, is often what separates successful investors from those who experience significant losses. 

To be sure, for those of you out there who have studied market cycles or have simply lived through them, you likely already understand that downturns are inevitable and, more often than not, unpredictable. 

Now, if you’re a seasoned investor with a high tolerance for risk, then you’re likely to remain steadfast in your investment strategy during periods of heightened market volatility because you understand the broader economic and market factors at work and anticipate the longer-term investment play at hand.

With all of that said, holding onto a concentrated position in market ups and downs isn’t always as simple as understanding the technical of market or economic factors. 

And why’s that?

Well, that’s because investing can, and often is, an emotional journey. To be sure, when market volatility picks up, and your net worth starts swinging to and fro, it can bring about strong emotional responses, like fear during downturns and euphoria during market rallies.

So then, within the context of investment risk tolerance, your emotional fortitude is a crucial trait to consider in these scenarios. Indeed, in these situations, you have to be able to resist reactive decision-making and stick to your long-term investment plan no matter what’s ahead of you. 

This approach is especially true when a large portion of your wealth is tied up in your company’s stock, and so you’ll need to be able to hold on without panicking during periods of negative news or poor earnings performance.

So then, how can you tell if you’re fit for holding concentrated investment positions? Well, the first thing you’ll want to do is to evaluate your inclination towards maintaining your financial acumen in your given investment holding. 

More specifically, you’ll need to ask yourself not only whether you’re well-versed in the intricacies of a given sector of the market or your company’s financials but also whether you have the mental bandwidth and time to stay on top of all the changes in both. 

Remember, more often than not, all it takes is one lousy report to send an investment plummeting, so you’ll need to stay on top of key developments so you can make wise decisions. 

Next, you’ll want to assess whether you have the intestinal fortitude to deal with a single large holding and its potential impact on your wealth. More specifically, you’ll need to determine whether you can endure periods of market turbulence without making rash decisions. For example, if you’re tempted to sell investments or simply move to the sidelines entirely during periods of heightened market volatility, then managing a concentrated position may not be the right fit for you.

And, when it comes to evaluating your risk tolerance within the context of managing a concentrated investment holding, you’ll want to consider your broader financial position. More specifically, you’ll want to look beyond your investments and evaluate your entire balance sheet. 

That’s why it’s essential to take some time to ask yourself whether you have the ability to absorb potential losses when markets go against your holdings without it impacting your lifestyle or financial goals. And, if you don’t have the financial flexibility to weather market downturns, then managing a concentrated position may not be for you.

Strategies for Managing Concentrated Investment Risk

Alright, so now that you understand what a concentrated position looks like, and have evaluated your own risk tolerance, what else can you do if you have concentrated investment risk that you can’t just walk away from, but you need to address in the present?

Well, managing concentrated investment risk often requires a strategic, multi-faceted approach that draws on a range of financial tools and principles to grow your wealth in a mindful way.

Indeed, when it comes to managing a concentrated position, you’ll need to consider several factors, from complex things like tax consequences to finding the right trade-off between risk and reward to make prudent choices with your holdings.

Diversification, Asset Allocation and Rebalancing to Manage Risks

And so, how do you go about managing these risks?

Well, to start, let’s come back to the first principles of diversification. Indeed, history has shown that, over the long term, you can reduce the overall risk in an investment portfolio when you spread your money across multiple holdings. To be sure, by investing in a broad range of assets, you reduce the risk associated with the poor performance of any one single investment.

And so, how do you achieve this outcome? Well, that’s where a solid asset allocation strategy comes into play. 

Remember, diversification is achieved by adding different asset classes (like stocks and bonds) to your portfolio, by investing in different sectors or countries, or by utilizing mutual funds or exchange-traded funds (ETFs) that offer instant diversification. 

Now, asset allocation, on the other hand, involves determining how much to allocate to these various investments, and more often than not, will be determined by your investment goals, risk preferences, and time horizon.

Alright, with all that said, a common question that typically comes up with respect to diversifying a concentrated position is whether you should sell all of your holdings at once and just be done with it or whether to do so over an extended period of time? 

Well, you could sell everything today, but there’s a host of factors at play, including tax consequences and the potential for missing out on investment gains to consider as well.

And so, depending on your situation, this is where portfolio rebalancing comes into play. 

Now, portfolio rebalancing is a proactive risk mitigation strategy that involves periodically buying or selling assets in your portfolio to maintain your desired asset allocation. 

And, in your situation, this could mean reducing a concentrated position by selling some of your investment holdings and then using the proceeds to invest in other underrepresented sectors or asset types. 

So then, by taking this approach, what you’re doing is preventing your portfolio from becoming overly concentrated in a single investment while ensuring it aligns with your investment goals and risk tolerance.

Okay, so now that you understand that to reduce concentration risk, you’ll need to spread it out across various assets, the next question is, “over what time period?” 

Well, if you have a long enough investment horizon, meaning that you don’t need to tap into the proceeds from your concentrated position for quite some time, then you might be able to bear the short-term volatility associated with a concentrated position with the expectation of higher returns in the long run as you begin diversifying away this position. 

With that said, however, if your investment horizon is short, meaning that you’ll need to tap into those investments sooner rather than later for, let’s say, a home purchase or for your early retirement, then an extended diversification strategy might be too risky since you likely won’t have sufficient time to recover from a potential market downturn when unexpected volatility hits.

Hedging as a Way to Manage Risks

Now, outside of rebalancing as a way to mitigate the risk of a single investment holding, another way to deal with a concentrated position involves hedging. 

And what do we mean here?

Well, hedging involves a rather deliberate process of making intricate investment decisions to transfer the risk of adverse price movements in a concentrated asset. 

You’re still with me, right?

Well, to put this process more simply, to achieve your desired outcome, what you’re going to do more often than not is use financial derivatives like options and futures to transfer risk (or hedge against) a potential decline in the value of your concentrated position.

Now, this concept can get pretty technical rather quickly, so let me give you an example to explain here. 

Let’s assume that you anticipate that the value of your company stock is likely to decline in the months ahead for any number of reasons. Well, in this situation, you could enter into a contract to buy put options, which gives you the right (but not the obligation) to sell a portion of your concentrated position at a locked-in price in the future. 

It’s like an insurance policy if the value of your concentrated position falls significantly, but it comes with its own set of costs and trade-offs and is helpful in specific situations.

Either way, when it comes to managing a concentrated investment position, you have several options to consider. And so, what’s critical to take away here is that if you do decide to hold onto a large position for the long-term, it’s essential to find a strategy that works for you and ultimately stay committed to it. 

Don’t Keep All Your Eggs in One Basket

You know, when it comes down to it, the road to successful investing, especially when it involves concentrated positions, requires a mix of self-awareness, emotional resilience, and strategic execution. Indeed, managing a concentrated investment position is like trying to balance on a high wire where the rewards may be as significant as the risks.

Make no mistake, however, managing a concentrated investment position is often a full-time job, and likely one reason why Warren Buffett encourages individual investors to buy a diversified basket of investments early and often. 

Even so, the risks are far from impossible, so long as you’re armed with the right tools and strategies, like knowing when you’re in a concentrated investment position and appreciating the risks and potential rewards of such positions.

And when it comes to successfully managing your concentrated investment position, understanding your investment horizon, portfolio rebalancing, and hedging strategies can help guide you through the often turbulent seas of investing.

To be sure, with these tools in hand, you’ll not only be better equipped to navigate the often stressful but many times rewarding path of investing, you’ll also be able to take one step closer to becoming the master of your own financial independence journey.