What is Concentration Risk?
Concentration risk arises when a portfolio is heavily weighted toward a single stock, sector, asset class, or geographic region. If that concentrated position suffers a downturn, the entire portfolio takes a disproportionate hit. A classic example is Enron employees who held over 60% of their retirement savings in company stock and lost nearly everything when the firm collapsed in 2001.
Measuring and Managing Concentration
A common rule of thumb is that no single position should exceed 5% of a diversified portfolio, and no single sector should exceed 25%. The Herfindahl-Hirschman Index (HHI) can quantify portfolio concentration by summing the squares of each holding's weight. An HHI below 0.10 indicates broad diversification, while values above 0.25 signal dangerous concentration. Rebalancing quarterly and setting maximum allocation limits per position are practical ways to keep concentration in check.
Key Considerations
Concentration is not always negative. Warren Buffett famously advocates concentrated bets on high-conviction ideas. However, this approach demands deep expertise and a long time horizon. For most investors, broad diversification across 20 or more uncorrelated positions significantly reduces the probability of catastrophic loss without sacrificing expected returns.