Saturday, September 28, 2013

Risk Management: Concentration Risk

Since I started the Greedy Dragon portfolio project, I’ve only invested in stocks from the finance industry. Currently I also have exposure to only 3 countries: The United States, Indonesia and Malaysia. My portfolio is not badly positioned though as my exposures to the finance industry and to the previously mentioned countries are within the constraints I set for this portfolio. The largest asset class of the Greedy Dragon portfolio is still cash which I really hope to put to work soon to get exposure to other industries and countries. Overexposure to cash is never good over the long-term. The interest earned on your bank deposits just can’t keep up with the big bad mofo called inflation.

In my opinion, an optimally positioned portfolio would have holdings in stocks that collectively generate profits from a geographically diversified customer base. This should mitigate the risk of serious economic or political events significantly screwing up your net worth, crushing your dreams and causing you to turn to crystal meth.

You shouldn’t diversify your portfolio to get exposure to foreign countries just for the sake of diversification. Before investing in foreign stocks, a couple of things must exist: 1) The country must be financially sound, politically stable and there must not be harsh regulations preventing foreign investors from reaping profits from their investments 2) The foreign company must be able to generate decent returns on capital and be trading at a reasonable valuation. 

Another thing to remember is that you don’t have to invest in foreign companies to get exposure to other countries. Some domestic companies generate a significant portion of their operating profits from foreign markets. Banco Santander might be listed in Spain, but it generates a lot of its profits from South America.

The following is an example of a portfolio that I would consider well-diversified geographically:

Mr Worldwide Portfolio

United States  30%
China             5%
India              5%
Europe           20%
Indonesia       10%
Malaysia       10%
Chile             7.5%
Brazil            7.5%

South Africa  5%

Another form of concentration risk is being overexposed to a specific industry. To mitigate this risk, a portfolio of stocks should also collectively generate profits from a number of different industries. This ensures that the ability of your portfolio to keep generating cash to pay you dividends or reinvest for the future will not be significantly impaired in the event that changes in the forces of a particular industry destroys the profitability of that industry. For instance, those damn environmentalists might wake up one day and realize that global warming as portrayed by the liberal media is bullshit. This could cause profits in the so-called green industries to evaporate. Oh wait, they were never really profitable in the first place. Never mind..

Anyway, investors shouldn't simply diversify into any random industry just for the sake of diversification. The industries you invest in must be within your circle of competence. The company you invest in also needs to be reasonably priced regardless of the industry it’s in. Finally, there are some industries that are so screwed up that it’s probably best just to avoid them completely.

Here’s an example of a portfolio that is exposed to a well-diversified range of industries:

Portfolio B (can’t think of any lame names)
Banking            30%
Mining/Oil        15%
Technology       15%
Consumer         30%
Real estate       10%


Last but not least, there's concentration risk that's related to the individual company. The company may rely on a very small number of clients for a large proportion of its revenue. This puts the company at risk of experiencing a large drop in revenue in the event that one of its main clients switch suppliers or go out of business. If a major client goes bankrupt, the company will even have to take a large write down on its accounts receivable if it extended a lot of credit to the client. 

A company may also be overexposed to a very risky asset class. For example: A bank may have large holdings of subprime loans in its loan portfolio. The bank will suffer large losses and may even face the risk of insolvency in the event that a large number of its subprime customers default on their loans.

I agree that an investor who knows his stuff shouldn't aim to establish a highly diversified portfolio. I’m certainly not recommending that an investor hold 30 stocks, or whatever number that’s in trend with the academics these days, in his portfolio. I’m just saying that we certainly can reduce wipe out risk by having exposures to various countries and industries. I think that if a competent investor does his research and have enough patience, he shouldn’t have too many problems sculpting out a portfolio that generates above average returns with a low level of concentration risk.  At least that's what I tell myself anyway.

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