Kevin Greenard: Concentration causes excess volatility

Kevin Greenard

Concentration within a portfolio refers to an individual equity, sector, currency, geographical area, etc. being overweight in the portfolio. Avoiding concentration is important to reduce overall portfolio risk. By having too much concentration, you are opening yourself up to excess volatility. In other words, never put all your eggs in one basket.

We have started working with new clients who have their entire portfolio in Canadian dollars with no US dollar or foreign exposure. For Canadians in particular, adding US dollar investments to the portfolio can help to smooth out volatility. In the past we have also had new clients come to us with excessive holdings where a single equity is greater than five per cent of the portfolio, and occasionally greater than ten per cent. We have also seen excessive sector exposure where if that given sector were to have a sharp pull back it could materially impact the portfolio.

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When assessing concentration, a general rule of thumb we use is that no individual equity position should exceed five per cent of the entire portfolio. Sticking to this discipline will ensure even the worst announcement by a corporation, or a pull back in a certain sector, will not materially impact your total portfolio.

Some of the most successful investors over time have held on to shares in companies for the long-term resulting in an overweight position within the portfolio. A portfolio concentrated in fewer positions may perform well, but more risk is assumed. It is important for investors to understand the degree of concentration within their portfolio in the context of their risk tolerance and entire financial picture. While concentration can cause undue volatility, having excess diversification for fear of being too concentrated can result in its own problems which we will discuss later in this article. Concentration risk is something that can be managed by developing a disciplined approach.

Managing concentration risk

To manage concentration risk, we calculate optimal position sizes for each of our clients. We use the term “optimal” to describe the dollar amount invested in each company in normal market conditions. These optimal position sizes are determined using asset mix and our recommended number of holdings, which is derived from your current portfolio size. We will first discuss these inputs individually, then illustrate how they are used in managing concentration risk.

Determining asset mix

Asset mix is determined based on several factors, such as: your risk tolerance, investment objectives, time horizon, investment knowledge, personal goals, current and future cash flow requirements, etc. Once asset mix has been decided on, it is documented in the Investment Policy Statement (IPS). A client who is in our moderate growth model portfolio would have 20 per cent fixed income and 80 per cent equities. If a client was in our balanced growth model portfolio, they would have 40 per cent fixed income and 60 per cent equities.

Determining the optimal number of holdings

Portfolio size determines how many individual equity holdings we recommend are held in our client’s portfolios at any time. This number of equity positions is directly used in calculating the optimal position size to manage concentration risk. Clients who have between $500,000 and under $5 million will typically hold a minimum of 25 holdings, while the optimal number of holdings is 30, and no more than 35. For clients with investment portfolios in excess of $5 million we recommend holding a minimum of 30 holdings, and the optimal number of holdings is 35 with no greater than 40 holdings in the portfolio.

Calculating optimal position size

To illustrate, we will calculate the optimal position size for two investors.

The first investor is Dr. Jillian Jones. Dr. Jones has a portfolio valued at $2.5 million. Given her risk tolerance and time horizon, she has a balanced growth portfolio where 60 per cent, or $1,500,000, is held in equities.

The second investor is Mr. and Mrs. Smith, who also have an investment portfolio of $2.5 million. Mr. and Mrs. Smith have a higher risk tolerance than Dr. Jones, and a longer time horizon, and as such are moderate growth investors with an optimal asset allocation of 80 per cent equities, or $2,000,000.

Dr. Jones’ optimal position size is $50,000 ($2,500,000 x 60 per cent equities equals $1,500,000 divided by 30 holdings).

Mr. and Mrs. Smith’s optimal position size is $66,667 ($2,500,000 x 80 per cent equities equals $1,500,000 divided by 30 holdings).

From this illustration you can see both how the optimal position size is calculated, and also how personal factors affect the optimal position size for each investor. Different investors have different risk tolerances. Without going through the exercise to calculate what your optimal position size is, one would not know their normal position, and could possibly be opening themselves up to unnecessary concentration risk. We have heard people say, “I purchase 100 shares of everything.” That simply does not work for a host of different reasons. The most obvious reason is that some stocks trade at very low prices per share and others at much higher prices.

Calculating half position size

While Dr. Jones and Mr. and Mrs. Smith each have an optimal position size, they also have a half position size. Sometimes we wish to underweight a holding or overweight a holding from a strategic sense in the short-term. If we feel that the markets are getting long in the tooth, or late in the bull market cycle, then reducing position sizes can be a strategic decision. This reduction would help if markets declined or had a correction. Another example of utilizing half position sizes may be a new client that has never invested before; to get their level of comfort up we may suggest half positions sizes to begin with. As time goes on, we would typically increase each position and work toward optimal position sizes.

Dr. Jones’ half position size is $25,000 ($50,000 x 50 per cent).

Mr. and Mrs. Smith’s half position size is $33,334 ($66,667 x 50 per cent).

Rebalance position size

While both client’s portfolio would be rebalanced at least once a year, we also calculate a rebalance position size for Dr. Jones and Mr. and Mrs. Smith. This is because if the markets have outperformed, it may indicate a need to rebalance in the interim.

If the long-term goal is no fewer than 25 names this is a natural starting point to calculating your rebalancing number. Whenever we are reviewing portfolios, one of the first items we look at is position size and if any holdings need to be rebalanced.

Dr. Jones’ rebalance position size is $60,000 (which is calculated as $1,500,000 divided by 25).

Mr. and Mrs. Smith’s rebalance position size is $80,000 (which is calculated as $2,000,000 divided by 25).

For example, we purchased $50,000 of Apple initially for Dr. Jones. Today, we see that the position size for Apple has increased to $65,644. At a minimum, we would recommend reducing the position by $5,644 ($65,644 - $60,000) to bring down to the rebalance position size, or reduce the position by $15,644 ($65,644 - $50,000) to bring down to the optimal position size.

Excessive positions

We also would look at any excessive positions our clients might have by taking the total value of their portfolio and multiplying it by five per cent. For Dr. Jones and Mr. and Mrs. Smith, their excessive position size is $125,000 ($2,500,000 x five per cent).

To illustrate, Mr. and Mrs. Smith hold Bank of Nova Scotia in their portfolio and it has appreciated in value over time. Now the market value of Mr. and Mrs. Smith’s Bank of Nova Scotia shares is $136,238, which is 5.45 per cent of their total portfolio ($136,238 divided by $2,500,000). In this scenario, we would discuss the concentration risk Mr. and Mrs. Smith’s excessive Bank of Nova Scotia position brings and suggest trimming the position by $56,238 ($136,238 - $80,000) to bring down to the rebalance position size, or reduce the position by $69,571 ($136,238 - $67,667) to bring down to the optimal position size. These funds could then be used to purchase a full position of a different holding, or to top up any existing holdings that have pulled back. If a client chooses to take an excessive holding in one company, we document the extra risk incurred within the IPS.

The consequences of not rebalancing

Within a well-designed portfolio, all positions have their place and their purpose. When clients choose to overweight one position, they are essentially deciding that they want to either underweight other names, not have all model portfolio names within their portfolio, or underweight another asset class, such as fixed income. Taking Dr. Jillian Jones’ example from above, her optimal position size is $50,000. Say Dr. Jones has an overweight position with a current market value of $100,000 (twice her optimal position size) that she has not wanted to part with. By choosing to maintain this overweight position, Dr. Jones is taking away another full position from her portfolio.

Risk of too little concentration

As eluded to above, having too little concentration within a portfolio has its own risks. We have had new clients transfer their investment portfolios to us in-kind and often see they have 80, 90, or in some cases more than 100 different holdings. While too much concentration may increase risk, a lack of concentration brings an entirely different host of problems.

If you were to list your favourite 100 companies from number one all the way down to 100, would you want to put the same dollar amount in company number 100 as you would in company number one? Likely this answer is no. By focusing on the top 30 to 35 companies worldwide you can benefit from concentration while still prudently managing risk. Having the disciplined approach to focus on the 30 best equity names can benefit you in the long run, while ensuring you don’t encounter excess volatility today.

Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Director, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250-389-2138, email greenard.group@scotiawealth.com and visit greenardgroup.com.

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