Over-concentration risk comes to the fore

15 April 2020 | Portfolio construction


Minimising concentration risk through a well-planned, well-diversified asset allocation strategy is one of the core principles of investing.

Across asset classes, this powerful strategy reduces a portfolio's exposure to the risks of any one class.

That fact has really come to the fore in the current investment environment, where certain sectors and companies have experienced much more substantial falls than the broader market.

Banks and property

The impact of the COVID-19 pandemic continues to be far-reaching across the globe, particularly for companies with exposures to all segments of the economy.

Right now, in the Australian context, it's difficult to look past what's occurring with the share prices of companies within the banking and financial sector and within the commercial property sector.

On average, the companies with these sectors have lost between 30 and 50 per cent since late February. That compares with the 27 per cent fall of the broader S&P/ASX 300 Index over the same period (as at 9 April, 2020).

More specifically, the share prices of the "big four" major banks – Commonwealth Bank, Westpac, National Australia Bank and ANZ – have dropped by between 30 and 40 per cent over less than two months.

Their shares are among the most widely held securities in Australian portfolios, and these four companies represent almost one-third of the total value of the domestic market.

There are now widespread expectations that all banks will suffer a sharp decline in revenues and earnings, and likely will experience a spike in bad and doubtful debts, as individuals and businesses struggle with the financial fallout emanating from the COVID-19 outbreak.

For bank shareholders, along with the plunge in the share prices is a strong likelihood of a cut to bank dividend payouts when companies announce their interim earnings results in May. The potential for cutting dividend income to shareholders has sparked further falls in bank share prices.

Systemic risks associated with COVID-19 are also flowing right across the commercial property sector.

Like the banks, listed property companies, otherwise known as Australian real estate investment trusts (AREITS), have seen their share prices fall since February.

As a whole, the AREITS sector – which encompasses the owners of shopping centres, office buildings, industrial sites and large-scale residential developers – is down more than 40 per cent.

Listed property companies have been hit especially hard as a result of the sudden closures of tens of thousands of big, medium and small businesses across Australia because of the current operating restrictions stemming from social distancing laws.

There are also numerous government measures now in place enabling tenants to seek reductions of deferrals in their rent, which for some property companies is causing severe cash flow issues.

These measures are flowing through to AREITS revenues and earnings, and potentially to dividends.

Reducing concentration risk

Concentration risk comes in different forms, from having an overweight exposure to specific companies and sectors, to having too much of a portfolio exposed to the domestic market (also known as home bias).

It can also arise as a result of stock picking strategies, where an investor chooses companies randomly on the basis of capital growth or dividend income expectations. The end result can be a poorly constructed portfolio that has large overlaps, because many of the companies chosen fall into the same industry.

When a systemic problem arises, such as those currently occurring with banks and property companies, over-exposed investors stand to record bigger losses than those with wider equity allocations.

Mitigating concentration risk is about having a much greater awareness of asset allocation strategies to reduce exposure to company and sector-specific issues, and to smooth out volatile trading conditions.

Diversified index funds, such as managed funds and exchange traded funds with wide-ranging holdings across one market or multiple markets, are prime vehicles for achieving this.

A financial adviser can play a key role in helping to minimise concentration risk by helping to define goals and recommending asset allocation tactics as part of a disciplined, long-term investment strategy.


Tony Kaye

Tony Kaye
Personal Finance Writer
Vanguard Australia