Putting all your eggs in one basket speaks to the essence of concentration risk.
Concentration risk in real estate is a scenario where an investor has put too much investment capital into a single property type or geographical location. If something happens to negatively affect these investments – a tornado in the Midwest, or a global pandemic that shuts down an industry sector, for example – the investor can be put in a difficult financial situation due to his or her lack of portfolio diversification.
This article takes a closer look at concentration risk and the various ways investors can attempt to manage that risk.
Factors That Can Contribute to Concentration Risk
Many different factors can lead to concentration risk. These include:
- Concentration of correlated assets. Investments that are broadly linked by industry or asset type can be adversely affected by downward movements in price or valuation. If you own a large amount of tech stock, for example, your overall portfolio could lose tremendous value if that industry sector experiences a sharp decline.
- Too many illiquid assets. Certain investment assets have set holding periods, or they lack a secondary market that makes divestiture difficult, if not impossible. This illiquidity could lead to the inability to access cash in a timely manner when you need it most.
- Concentration on one property type: Investing too heavily in one property type could lead to significant asset devaluation during adverse economic conditions. Look at what happened to the retail, hospitality, and office sectors of commercial real estate during the pandemic – these industries shut down almost completely for a time. The impact was felt especially hard among non-essential retailers, many of which ended up closing their doors. In the hospitality sector, Covid wiped out nearly 10 years of job growth.¹ And the work-from-home office trend continues to be the new working model among large and small corporations. These trends continue to affect each sector, though several have experienced significant recovery from the effects of the pandemic.
- Concentration on a singular geographical location. In many markets, especially secondary and tertiary markets, real estate historically undergoes cyclical swings in valuation. Bear runs could erode investment values. Primary markets tend to be more bullish, however, so they can be more insulated from cyclical pricing swings.²
Ways Investors Can Attempt to Manage Concentration Risk
According to the Financial Industry Regulatory Authority, portfolio diversification is the single-most-important strategy to deploy in an attempt to manage investment risk – although diversification may not be enough to outweigh the negative impacts of concentration risk in certain situations.³
Portfolio diversification as a means to manage concentration risk involves spreading your investment capital across a wide range of asset classes and investment types. This practice can reduce concentration risk and also reduce your exposure to market volatility or asset devaluations. Two important factors to consider when rebalancing your portfolio in an attempt to manage concentration risk include your investment horizon and risk tolerance. These factors will largely determine which types of investments are a good fit for your risk profile.
The Bottom Line
Diversification across and within varying asset classes and investment sectors is one way of managing concentration risk. A balanced portfolio with holdings across a wide range of stocks, bonds, mutual funds, and alternative investments can reduce investor exposure to concentration risk. Investors also may need to regularly rebalance their portfolios when concentration risk is a primary concern.
Concentration risk can be difficult to identify. Investors may want to consider engaging the counsel of experienced investment and financial professionals to better help manage their exposure to concentration risk.
Sources:
1. Coronavirus Pandemic Sets Hotel Industry Back 10 Years, Report Finds, U.S. News and World Report, https://www.usnews.com/news/national-news/articles/2021-01-27/coronavirus-pandemic-sets-hotel-industry-back-10-years-report-finds
2. Bouncing Back: 2022 Commercial Real Estate Outlook, JP Morgan | Chase, https://www.jpmorgan.com/commercial-banking/insights/2022-commercial-real-estate-market-trends
3. Concentrate on Concentration Risk, FINRA, https://www.finra.org/investors/learn-to-invest/advanced-investing/concentration-risk
