How to Reduce Your Concentration Risk Through Diversification
You might be wondering from the title of this post, “What is concentration risk? How does this pertains to me?” That is a great question worth answering. As a matter of fact, I guarantee that you have dealt with some form of concentration risk in your life.
Concentration Risk is a fancy term for having too many of your eggs in one basket. This type of over-concentration in one asset class is something that an intelligent investor should avoid at all costs.
If you want to figure out if you’re currently experiencing a form of concentration risk, here are some examples to consider:
- Tied to one employer
- Too much money in one stock
- Too much money in one Brokerage/Bank account
- One health insurance plan
- Living in one home that you own.
These are only a few examples; we could keep adding to this list. Note that you are subjected to concentration risk every time you are tied into one item which, if that certain item was taken away, would cause strain in your life.
Sometimes concentration risk could be good thing; for instance, if you own a dream home, if you are married to your dream person, or if you are working your dream job.
However, when you’d like to decrease the amount of concentration risk in your life, it is time to begin the process of diversification.
The Process of Diversifying Concentration Risk
How do we embark on this path? Below are the steps towards diversification.
- Identify areas in which you would like to being diversifying. Find a quite place and take 15 minutes to lay out areas in your life where you might be subjected to concentration risk. Key in on areas where, if the thing(s) were taken away, you would be scrambling to replace or rectify the situation.
- Key in on one area and begin figuring out how you can diversify. Start small. Focus on one area and begin to develop the plan to diversify. Once you have some momentum, then begin working on the next area.
- Begin implementing your diversification steps. Planning is nothing without action. Get started TODAY!
- Make slow, steady gains towards diversification. Develop key metrics and track the progress towards achieving your diversification goals. The momentum of the ‘brick-by-brick’ gains that you will see will continue to propel you to greater and greater heights!
If you’re currently experiencing concentration risks in the areas mentioned above, here are some diversification ideas that can help you reduce your risk:
If you are tied to one employer
Begin a side hustle or become a freelance/contract worker. Nothing is worse than being the position of having 100% of your income from one source. Not only is your negotiation power next to zero with your company but if you happen to lose that income source for whatever reason, you’re down to 0% of income coming in. This is not a good position to be in.
Starting up a side hustle is a challenging endeavor but our advice of starting small is the best way to proceed forward. Set a goal for making an extra $20 a month and keep moving up from there. Once you get some momentum behind you, the gains will come easy!
If you have too much money in one stock
Steadily sell a part of the stock and re-deploy in a different stock. Have a certain percentage dollar amount that you are willing to accept as concentration risk for your portfolio. I currently have 15% set as my concentration risk for one stock.
I would recommend you have a similar percentage which you allocate towards ownership of one stock so as to mitigate risk should one company have a year of negative news and the stock price takes a dive. Plus it is a good feeling that when you see one stock go down, a few others go up – this helps you understand that stocks will always fluctuate but if you diversify your holdings, you are investing correctly.
If you have too much money in one Brokerage/Bank account
Create multiple brokerage accounts and spread your investments around.
Most brokerage accounts should be subjected to $250k FDIC insurance on the account. Keep in mind this insurance does not cover losses on the stock value but only if the brokerage becomes defunct.
I have used Firstrade as my brokerage for many years and have been happy with the results. Etrade is another solid platform as well. If you’d like to know more, click here to find the right broker for your needs.
For my savings account, I have used CaptialOne 360 for many years. Click on that link and earn a bonus for signing up!
If you have one health insurance plan
This is a tough one to diversify away from. If you are an employee, the government and the employer are incentivized to tie you to employment, so you will most likely have a company provided insurance plan while you are employed with the company.
I only mention this as having a company provided insurance plan is another way your concentration risk is increased. If the job goes away, the insurance will eventually go away. The best remedy is to know your options. In case you need to switch, know what other health insurance plans are out there. Knowledge and preparation are keys to success.
If you live in one home that you own
Housing can be tough to diversify away from as we all need a place to live. I advocate viewing the home that you live in not as an investment but rather as your place to live.
A few good diversification options are to own multiple homes or rent so that you are flexible and able to move if needed. Now, I know owning multiple homes is not always an option for everyone out there but the reality of the 2008-2009 housing crisis is that if you own a home and need to move but the market has moved against you, you’ll either be forced into a short-sale or have to to remain in the home until the market recovers. Market recovery in housing is usually a matter of years, not months.
With that being said, make sure that you are understanding the current Housing Dynamics as well as know your Price/Square Foot ratio.
Summary
Hopefully this article has gotten you to think more about concentration risk in your life. If you would like to begin diversifying, the time is now! Upwards and Onwards to Financial Freedom!
Disclaimer: (1) All the information above is not a recommendation for or against any investment vehicle or money management strategy. It should not be construed as advice and each individual that invests needs to take up any decision with the utmost care and diligence. Please seek the advice of a competent business professional before making any financial decision.
(2) This website may contain affiliate links. My goal is to continue to provide you free content and to do so, I may market affiliates from time-to-time. I would appreciate you supporting the sponsors of MoneyByRamey.com as they keep me in business!
