Concentration risk: When winners (and company shares) take over your portfolio

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If your glass isn’t half empty, your bucket might get too full.

© ILYA AKINSHIN/stock.adobe.com; Photo illustration Encyclopædia Britannica, Inc.

“Ride your winners and cut your losers.”

That sage, but well-worn, trader adage works when you’re managing positions and following trends. But carry that mindset into long-term investing, and it can become a double-edged sword. Over time, those outperformers can grow into outsize positions that dominate your portfolio. And if those winners cluster in the same sector or industry (e.g., information technology in the early 2020s), your portfolio can become heavily dependent on a narrow slice of the market.

It’s called concentration risk—and it often builds quietly, only becoming obvious when that one stock, sector, or theme starts moving the wrong way. It can also show up when your income and investments are tied to the same place—for example, if you hold a large amount of your employer’s stock through compensation or retirement plans.

Concentration risk occurs when a portfolio’s performance depends too heavily on a single asset or set of correlated assets. Over-concentration can take various forms:

In short, concentration risk is what happens when you keep all of your eggs in one basket, as the saying goes.

In practice, concentration risk usually comes down to two measurable factors: how much of the portfolio is allocated to a given asset, and how closely the holdings move together.

Imagine a vegetarian pizza where all of the olives are stacked on just a couple of slices—or all on one half of the pie. There’s a clear imbalance. The same logic applies to investments.

There’s no universal rule on percentages, but there are general guidelines that industry pros follow:

What’s being measured here is the exposure to a single risk factor. When a sector or the broader market declines, a well-diversified portfolio may contain assets that fall, remain relatively stable, or even rise. But when exposure is heavily concentrated in a single stock or sector, that one risk can pull the entire portfolio down.

When certain market sectors start outperforming others, does the bulk of your portfolio value shift significantly one way or the other? If so, perhaps you have too many stocks moving in near-lockstep. In short, your portfolio may be too concentrated among a small number of investments.

Correlation is a way of measuring how stocks move relative to one another. For example:

Highly correlated stocks tend to concentrate potential growth as well as risks. Less-correlated positions are more diversified. Noncorrelated and negatively correlated assets, like a gold exchange-traded fund (ETF) against a U.S. dollar index ETF, help reduce concentration risk as they move independently of the rest of your portfolio (noncorrelation) or in the opposite direction (negatively correlated).

When you’re in (or nearing) retirement, concentration risks tend to become more pronounced. Here are four scenarios to watch out for.

Younger investors have one indisputable advantage over older ones: time. If a 35-year-old loses 50% in portfolio value, they may have 20 to 30 years to recover the losses. But if a 65-year-old loses 50%, recovery becomes much more difficult, as they may need to draw income from it immediately. That’s why advisors recommend keeping a higher percentage—say, 70%—of investor portfolios in stocks in the early years, but rebalancing in favor of less risky assets as retirement approaches. (Such strategies are built into the allocation of target-date funds.)

Over the long term, markets tend to generate positive returns—but they don’t travel in a straight line. That’s OK if you have a long investing horizon (see above), but what if the worst period comes right as you hit your retirement years? That’s sequence-of-returns risk, and it can significantly deplete a portfolio’s value and cumulative returns.

Imagine two retirees, each with a $1,000,000 portfolio. Each retiree withdraws $50,000 per year. In a three-year period, each has two years of 25% return and one year of -25% return—but in different sequences. Here’s how it might play out:

By the end of the third year, Investor A’s portfolio is worth $981,250 after a steady sequence of withdrawals in the amount of $50,000.

The same nominal annual returns produced different outcomes depending on the order in which they occurred. A loss in the early years of retirement can take years to recover, especially if you have no flexibility in terms of withdrawal amount.

Before retirement, your job (or your business) was your main source of income. Fluctuations in your investment portfolio didn’t affect your base income. After retirement, however, your portfolio becomes your paycheck, so to speak.

If a large portion of your portfolio is concentrated in one stock, sector, or correlated group of assets, your income stream can be greatly affected—positively or negatively—depending on what the market does.

For example, if you plan to withdraw 4% from a $1M portfolio, that’s $40K. But if concentration causes it to drop to, say, $700K, your 4% withdrawal shrinks to $28K. The difference between the two is a pronounced lifestyle change.

The tax lock-in effect occurs when investors hesitate to sell appreciated assets because of the capital gains tax they’d owe, even if those positions have grown too large.

Suppose that you invested 20% of your portfolio into tech stocks before retirement, and several decades of strong performance pushed that allocation to 60%. You might be hesitant to sell because you don’t want to pay the capital gains tax. You might be reluctant to trim the position to avoid a large tax bill. But holding on leaves your portfolio heavily concentrated. If the tech sector declines, the resulting drawdown can significantly reduce your base for withdrawals—at a point when there may be little time to recover.

If you’re holding an outsize position in a single asset or group of correlated assets, there are several ways to reduce your exposure:

These strategies can be complex, so you may need the help of a financial professional to fully understand them. For example, if you’re a high-net-worth investor sitting on a large block of company stock, it may make sense to incorporate those shares into a broader charitable giving or estate plan.

Concentration risk often creeps into your portfolio over time. It’s what happens when successful holdings grow at a faster rate than others. But if these strong performers grow so large that your portfolio depends on their returns, those “winners” can make your entire portfolio vulnerable. By rebalancing your allocations, maintaining a reasonable degree of diversification, and managing your tax burden by strategically trimming positions, you can help keep a strong portfolio from turning into an investment risk.