The following investment opinion is by Rufus Mwanyasi, the head of Canaan Capital.
Safaricom CEO Bob Collymore’s decision to publicly declare his wealth as part of efforts to fight corruption no doubt set a new standard for corporate executives in the country.
Incidentally, as a result of the decision, his asset allocation strategy became public knowledge; 19 per cent in real estate, 42 per cent in cash and 39 per cent in shares.
Overall, the portfolio revealed a very conservative style which is quite normal for any investor heading into his 60s and probably planning to start relying heavily on his/her accumulated wealth.
However, looking underneath the equity portion shows the portfolios’ weakest link; a concentrated position in two related companies — Safaricom and Vodafone.
In this article, I seek to educate investors about the hidden risks associated with holding significant wealth in concentrated positions.
First, let us define a concentrated position. This is when an investor owns shares of a stock (or other security type) that represents a large percentage of his or her overall portfolio.
Typically, a position that represents 10 per cent or more of one’s portfolio is deemed a concentrated position. Therefore, in this case, Mr Collymore’s 39 per cent allocation in two stocks qualifies as a concentrated position.
So why is a diversified portfolio better than a single stock position? The answer lies in lower volatility. Research shows that concentrated positions tend to fluctuate violently (for example, have higher volatility) compared to diversified positions, a situation which ultimately lowers long-term returns.
For this reason, controlling volatility and risk through proper diversification should matter in portfolio management.
Recent history is full of stories of investors and employees who were crushed by the fall of their employer (read Enron and WorldCom) not necessarily because of the fraud, but rather due to the overwhelmingly large positions allocation to one position.
Consider the advice of many financial advisors to keep a maximum of five to 10 per cent of total investment assets in the employer’s stock.
Despite these seemingly valid reasons, some investors still choose to hold concentrated positions and reasons vary widely. For some, the belief that past performance will continue indefinitely, makes it difficult for them to imagine a downside.
Yet others choose this way for fear of regretting selling a stock if the price continues to rise or because they received the stock as an inheritance from a trusted family member.
While it is tempting to believe in concentrated positions, research shows that investments in a diversified portfolio will produce greater long-term wealth than investments in a concentrated position, with significantly less risk.
Investors should realise that investing this way does not compensate them for taking this risk. One more thing. Just because stocks are riskier investments that should provide higher returns than less-risky investments like Treasury securities, this risk/reward premium turns against the investor who owns too few stocks, and especially when the investor holds a single or large, dominant position.
This is because returns become too reliant on the fortunes of one company (exposing the investor to significant company-specific fundamentals risk) and to a single industry (exposing the investor to sector-specific risks).
In all, consider it wise to diversify a concentrated stock position whenever possible to avoid these risks.