Risk & Money Management · Intermediate · 5 min
Concentration risk
You can recognize concentration risk in a portfolio and in your life, and explain why the Enron 401(k) plan became a warning example.
Too much of one thing
Some of the largest losses private investors suffer do not come from bad trades. They come from holding too much of one thing for too long: one share that kept rising, one sector everyone loved, or the company they work for.
It rarely feels risky while it happens. The holding is familiar, often successful, and it seems loyal or smart to keep it. That is what makes concentration so dangerous.
One slice dominates
Concentration risk is the risk that a single holding, sector, country, theme or employer makes up so much of your money that one bad event there does outsized damage. It is the opposite side of diversification.
Concentration often builds quietly:
- Winners grow. A share that triples becomes a much larger part of the portfolio than planned.
- Familiarity. People tend to buy what they know: their employer, their home country, the brands they use. The lesson on home bias showed this for countries.
- Themes. Several funds or shares that all depend on the same trend.
- Trading accounts. Most of the open risk ends up in one asset or one direction.
The best-known warning example is Enron. At a US Senate hearing in February 2002, after the company's collapse, testimony stated that as of 31 December 2000, 62% of the assets in Enron's 401(k) retirement plan consisted of Enron stock. The chairman's statement at the same hearing said that Enron workers had more than 60% of their 401(k) assets in the company's stock.
The testimony also named the double problem: employees were concentrating their savings in a single stock that was highly correlated with their own job. When Enron failed, many lost their income and a large part of their retirement savings together.
The usual answer is a limit: a maximum share of the portfolio for any single holding, and for any single sector or theme, checked regularly.
Savings and job, one risk
A fictional employee has saved 50,000. Over the years, bonuses paid in company stock and a rising share price have pushed the employer's stock to 31,000, or 62%.
- If the employer's stock falls 80%, the 31,000 becomes 6,200.
- The savings drop from 50,000 to 25,200, a loss of almost half.
- A crisis that hits the share price that hard may also put the job at risk.
With a limit of 10% per single holding, the employer's stock would have been at most 5,000. The same 80% fall would have cost 4,000, or 8% of the savings.
Common mistakes
- Letting winners grow without limit. Check holdings against your maximum share regularly.
- Owning the employer twice. Your job already depends on the company.
- Several funds, one theme. Different names can hold the same companies.
- Thinking a strong company cannot fail. At the 2002 hearing, Enron's collapse was called the largest bankruptcy in US history.
- Not counting company stock in a pension plan. It belongs in the same total as the rest of your savings.
The takeaway
Concentration risk means one holding, sector or employer can do outsized damage. Set a limit before it grows past it.
Check yourself
Quick quiz
4 questions. Instant feedback, nothing is saved.
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1Tap the part that ties this person's savings to their job.
Tap the chart.
If the employer runs into trouble, both the job and 62% of the savings are hit at the same time.
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2At the end of 2000, what share of the assets in Enron's 401(k) plan was Enron stock, according to testimony at a 2002 Senate hearing?
Testimony at the hearing stated that as of 31 December 2000, 62% of the plan's assets consisted of Enron stock.
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3Why is owning a lot of your employer's stock an especially concentrated risk?
The testimony pointed out that such holdings are highly correlated with the employee's own human capital: the job.
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4Which is a typical sign of concentration risk in a trading account?
Concentration is about where the risk sits. One bad event in that area then hits most of the account.
of 4 correct.