As an investor, you have no doubt heard the phrase “don’t put all of your eggs in one basket.” Most investors have a general understanding that proper diversification is a key part of a successful portfolio. Though, in practice, creating a properly diversified portfolio is far more challenging than you may realize. All too often, investors (and their brokers) over-concentrate investments, dramatically increasing the risk of catastrophic losses.
At Sonn Law Group, our securities fraud attorneys are committed to increasing investor education. We know that the most important investor right is the right to be fully informed. Here, our legal team explains what investors need to know about concentration risk, including why over-concentration occurs, how to avoid it and when you can hold your broker or broker-dealer legally liable for investment losses that were incurred because of your portfolio’s lack of diversification.
The market is a notoriously fickle thing: today’s hottest stocks often become tomorrow’s biggest losers. This story has been repeated time and time again throughout history. In the late 1990s internet-based companies were all the rage; by 2001 the Dot-com bubble had burst, and many of the most prominent tech stocks had lost more than 90 percent of their value.
Investors who held all of their eggs in the tech basket suffered devastating losses. By the end of 2006, U.S. real estate prices were through the roof; within two years, the subprime mortgage crisis would crush investors who were over-concentrated in real estate.
These examples are two of the many that demonstrate why proper diversification is the cornerstone of any well-positioned portfolio. Simply put, diversification is one of the best methods to reduce your risk. If your investment holdings are heavily concentrated in one area, or a few similar areas, your losses will be amplified anytime a downturn occurs. The hard truth that all investors need to remember is that any type of investment could fall at any moment. To protect yourself, you need to diversify your holdings.
Unfortunately, some investors get lured into to over-concentrating their portfolio into one asset class or one sector of the economy. This happens for many different reasons, sometimes because of the mistaken belief that one type of investment is guaranteed, while other times because their negligent broker gave them poor advice.
A portfolio that was once well-diversified can actually become over-concentrated as time passes, if certain investments perform strongly. For example, if your technology stocks have boomed over the last twelve months, you may find that this asset class suddenly represents a huge percentage of your holdings. At this point, it is time to adjust your portfolio.
Some companies give their employees ‘stock’ as part of their benefits or retirement package. The Financial Industry Regulatory Authority (FINRA) has repeatedly warned investors not to rely too much on their own company’s stock. Like any other business, your company could see hard times.
Certain investment assets are correlated with each other. This means that you could be overly exposed to a certain type of risk without even knowing it. Your registered investment adviser (RIA) has a professional obligation to ensure that your portfolio is structured properly to avoid the risks posed by owning correlated assets.
Finally, investors need to be mindful of illiquid investments. Certain types of assets, such as non-traded real estate investment trusts (REITs), are extremely difficult to sell quickly. As such, you may end up getting ‘stuck’ holding this type of investment, unable to rebalance your portfolio should something go wrong.
The best thing you can do to protect yourself against concentration risk: Hold investments from several different types of asset classes. You should consider holding stocks (from many different sectors), bonds (with different issuers and different maturity periods) and real estate. By diversifying across asset classes, you will be able to limit your risk most effectively.
Your investment holdings should be re-balanced at regular intervals. You do not (and probably should not) make frequent trades, but you do need to make periodic adjustments to your portfolio to prevent over concentration. You and your broker should regularly review your investments in order to ensure that your current holdings are still consistent with your overall objectives.
If you hold mutual funds or exchange traded funds (ETFs), you should have a basic understanding of what specific investments actually make up those funds.
In some cases, investors believe that they are properly diversified, but they are actually holding mutual funds and ETFs with many overlapping assets. You should always look to see what your investment consists of.
Your broker has a fiduciary duty to look out for your best financial interests. If they fail to live up to that professional obligation, then you can bring a civil claim, seeking fair compensation for your investment losses.
One aspect of your broker’s duty is to ensure that you have a well-diversified portfolio. Your broker should always be giving your needs proper care and attention, and conducting trades and making recommendations with adequate professional skill.
If your portfolio became over-concentrated, either because of your broker’s desire to seek higher commissions, or because of their negligence, then you may be entitled to compensation for your losses. Your claim should be reviewed by a qualified investor losses attorney immediately.
At Sonn Law Group, we are fierce advocates for investors. If you lost money because your broker acted negligently, and failed to properly diversify your holdings, we can help you seek compensation for your investment losses. To set up a free, no obligation review of your over-concentration of funds claim, please call our legal team today at (877) 872-5272. From our primary office in South Florida, we represent investors nationwide.