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FINRA Urges Focus on “Concentration Risk”

No two investors are the same. They have different income goals, different risk tolerances, and different time horizons—among other differentiating factors. Indeed, one of the most common ways in which investors and brokers get into disputes with each other is through complaints of “unsuitability.” This is an argument by the investor that his or her portfolio is not right for him or her. In other words, just because certain investments and securities might fit perfectly in the portfolio of one of the broker’s clients doesn’t mean it fits within another.

Recently, FINRA stressed the importance of investors themselves keeping watch of their own portfolios. The regulator urged investors to pay particular attention to one specific pitfall that many, if not most, investors should be careful avoid: concentration risk.

Minimizing Concentration Risk

Generally, concentration risk is the increased risk of losses that may occur due to a having large portion of your portfolio invested in a particular security, type of security, or market segment. But this simplified definition perhaps does not suggest how tricky concentration risk can be to avoid.

As FINRA explains, “a diversified portfolio tends to be harder to achieve than simply following the mantra: don’t put all your investment eggs in one basket.”

Investors are urged, then, to both understand the most common root causes of a portfolio with a large amount of concentration risk and understand how best to avoid them.

Common Reasons for Concentration Risk

First, FINRA notes that such portfolios are often intentional, due to the investor’s belief that the particular stock, for example, is bound to rise in value. Second, the concentration in one area may simply be due to asset performance: one security or type of security may have recently outperformed the others.

Third, employees are often drawn to the stock of their employer, a strategy regarding which FINRA has repeatedly urged caution. Fourth, concentration may occur because of so-called “asset correlation.” This means that investments are much more related than they appear. An investor could, for example, own shares in a particular company directly and shares in a fund that itself owns a large amount of that stock.

And fifth, concentration may build up around illiquid assets. If an investor is repeatedly drawn to non-traded REITs or small private placements, the investor’s portfolio may become increasingly clogged with assets that he or she can’t sell.

Avoiding Concentration Risk

As a result of the above, then, certain portfolios may be bearing an undue amount of concentration risk, which can be avoided or mitigated in a number of ways.

The investor can and should diversity across (and within) the major asset classes. FINRA advises investors to spread out their money so that no one sector or instrument can crash the whole. Investors should also take care to “rebalance” regularly. They should make periodic reviews of their portfolios, in efforts to minimize concentration risk. And this should be the case whether the portfolio is managed directly by the investor or through a broker.

FINRA also recommends that investors “look under the hood” of mutual funds or ETFs. These should be examined for the same risks as a portfolio with individualized investments. Fund-centric portfolios do not necessarily mean they are properly diversified. And finally, investors should understand and appreciate the liquidity of their investments: When and under what circumstances can a security be sold? Armed with this information, an investor can make better decisions about the direction of the portfolio in general.

If you believe your portfolio is over-concentrated or that you have been the victim of securities fraud or some other kind of financial exploitation, please contact attorney Gregory Tendrich, P.A. to discuss your legal options today.

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