In this episode of "Nurturing Financial Freedom," we discuss the crucial topic of the dangers of putting too much money into a single investment, often referred to as concentration risk.
Alex starts by explaining that concentration risk, while not unique to any one type of investment, is particularly prevalent in stocks. He dispels the common "eggs in one basket" analogy by emphasizing that diversification means more than just spreading investments across similar types. True diversification involves spreading investments across different asset classes to reduce risk.
Alex outlines two main problems with overconcentration. First, the actual investment result can be highly unpredictable. While betting heavily on a successful company like Google or Amazon at the right time could have been life-changing, many other seemingly promising stocks like Pets.com or Copper Mountain did not deliver. The second problem is the moral hazard that success can create. If an investor gets lucky once, they might believe they are smarter than the market, leading to risky behavior that can eventually result in significant losses.
Jag draws a parallel with gambling, noting that while investing done right has a positive long-term expectation, gambling generally does not. Alex agrees, stressing that concentrating money in a single security is akin to gambling and should be avoided.
Ed then discusses two types of overconcentration: voluntary and automatic. Voluntary overconcentration happens when investors intentionally buy large amounts of a single stock, often due to recent performance. Automatic overconcentration occurs when employees accumulate large amounts of their employer's stock through compensation packages. He explains the psychological factors at play, including recency bias, where people expect recent trends to continue indefinitely, and loyalty to their company, which can cloud judgment.
Ed also highlights the practical issues, such as tax liabilities and the emotional difficulty of selling high-performing stocks. He shares a cautionary tale of a pharmaceutical company whose stock plummeted due to unforeseen issues, causing employees to lose significant portions of their net worth and even their jobs. This example underscores the importance of not being overly reliant on any single company, especially one’s employer.
To mitigate these risks, Alex advises that no more than 5% of a portfolio should be invested in a single security, with a cautious approach to anything between 5% and 10%. Exceeding this 10% can make financial planning difficult, as the range of potential outcomes becomes too broad and unpredictable.
Jag and Ed conclude by reinforcing the importance of a diversified portfolio for long-term financial success. They stress that while high-risk bets can occasionally pay off, the potential for catastrophic losses makes them unsuitable for most investors. Instead, maintaining a balanced and diversified investment strategy helps ensure financial stability and success.