Concentration Risk
Here’s a tough truth for some investors to comprehend: most of the richest people in the world achieved their financial success via a heavy concentration in a single company (stock), yet it would be wise for all investors to be diversified.
This is the classic exception-not-the-rule principle. What may have worked well for someone else could be incredibly unsuitable or dangerous for you.
We don’t always fully understand or appreciate risk. We become enamored by potential returns and simply forget about risk.
I recently spoke with a potential new client of The Bahnsen Group. He was describing to me his do-it-yourself approach and the outcomes he had experienced. Based on the numbers and the growth he described, I was initially quite impressed. Then I got the opportunity to peel back the curtain and study the actual holdings. 40% of the portfolio was in two companies. It was this very concentration that had created the above-average outcomes.
I let him know that I was extremely happy for him and how the past had played out. I was also candid about the luck factor in these outcomes, and the prudent decision going forward would be to diversify. This type of advice isn’t easy to digest because it can lead to the false assumption that what worked before will continue to work. If I ran across the freeway and made it to the other side safely, should I assume the same result if I try it again?
Our conversation ended with this investor telling me that he predicted these two companies would most likely triple in value over the next five years. What an audacious statement, and an exact reflection of how past outcomes can blur our vision of current risks.
When Genius Failed
I recently read “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” It was shocking how similar this story was to my conversation with the investor described above.
It was in the late 90’s that LTCM collapsed, which led the Federal Reserve Bank of New York to coordinate a bailout involving the largest banks in the country.
To me, the collapse wasn’t the most interesting part of the tale; rather, it was the backstory and the attitude of LTCM’s leadership at the fund’s inception. The founding members were made up of notable practitioners (traders) and Nobel Prize-winning academics. The approach was rooted in academic models in which risk was neatly calculated and caged into a range of controlled outcomes. An early letter to investors even went as far as assigning exact percentages to potential drawdowns in the fund and how often these outcomes should be expected.
One thing we can clearly learn from history is that risk cannot be caged or tamed. Outcomes are not limited to the path or rhythms of history. What’s happened before can provide context, but the past simply isn’t prologue.
When describing the improbable outcomes LTCM experienced, the author said, “It was a 100-year flood—but it was happening for the third time in a few years.”
Probable vs. Possible
In the personal finance industry, the field of financial planning makes a similar mistake when trying to statistically describe risk. There is such a heavy reliance and usage on the Monte Carlo simulations that investors/planners can become desensitized to the way the world actually works. A dispersion of potential outcomes becomes a relied on framework for what will happen, but it is really just describing what could happen.
In these planning exercises, probabilities begin to replace possibilities. Yet, as we know, life is full of endless possibilities – both good and bad; surprises to the upside and incredible disappointments. The Monte Carlo simulation simply doesn’t capture winning the lotto, a cancer diagnosis or any other life surprise. Ultimately, the dispersion of potential outcomes is closer to endless than defined.
I even think about what I read a few weeks ago. The headline almost seemed like a hoax: “Man Runs Marathon Sub Two Hours.” I thought to myself, “There is no way that could be possible!” Yet, he did it. Sebastian Sawe hit a pace of nearly 4:30 per mile. Absolutely mind-blowing.
The Power of a Pivot
One of the simplest, yet most powerful, moves within the rules of basketball is the pivot. Sure, once you pick up the ball, you can no longer dribble, but you can still change direction and juke out your defender – this is the power of the pivot, or the more evolved version of the pivot, the Euro step.
Financial plans live in a linear world where many of the assumptions are static, and this creates a reliance on predicting a myriad of variables. These plans are good for testing viability and providing context, but it would be both rigid and silly to think that these plans would perfectly forecast future outcomes. Risk just has a way of disrupting our plans and creating surprises. I like the way that financial planner Carl Richards describes it: “Risk is what’s left over after you think you’ve thought of everything.”
Risk is the reason that insurance is so important. Our ability to pay reasonable premiums to cover the cost of low probability and detrimental outcomes.
Risk is the reason humility is so important. We will never know an outcome for certain, and it is in our best interest to temper our confidence around our assumptions.
Risk is the reason pivots are so important. We need to become comfortable with change, and we need options that allow us to easily shift in a different direction.
Simply said, we can’t eliminate risk, so we must learn how best to live with it.
Trevor Cummings
PWA Group Director, Partner
