Concentration risk and investment manager risk are two of the perils you will face when investing in a portfolio of risky assets. Even what may appear to be a balanced and well-diversified portfolio -- with many types of assets and collection of various sectors in the economy -- can expose you to one or both types of risks. Understanding these risks will help you better cope with them and make you a smarter investor.
Diversification and Covariance
When investing in the stock market, you shouldn't put all your eggs into a single basket, but instead buy a portfolio of stocks. However, the relationships of the stocks in your portfolio matter as much as the number of stocks. If the stocks are highly correlated, which means they have a tendency to go up and down together, you don't gain much from adding more stocks. Such stocks are said to exhibit high covariance. Instead, you want stocks with low covariance -- stocks whose up and down movements are as independent of each other as possible.
Assume you buy a mutual fund, which has invested in 100 stocks. You sleep soundly at night until one day you note that the fund's total value is down 10% in a day. Upon closer inspection, you realize that almost half of the fund's money was invested in transportation stocks, such as trucking companies, airlines and freight carriers. A look at newspapers reveals that the sharp rise in fuel prices hit all transportation stocks since these companies use massive quantities of fuel. This is concentration risk. Despite holding many stocks, a large number of them were exposed to the same risk factors.
Investment Manager Risk
Investment manager risk is a broad term that encompasses essentially all losses arising from the mistakes, negligence and incompetency of the managers in charge of a financial portfolio. The category is so broad that without further clarification of which kind of mistake the investment manager has made, it's relatively meaningless. Concentration risk, for example, is a type of investment manager risk. After all, it is the failure of the investment manager to select a diversified portfolio that results in concentration risk. Essentially all kinds of risks except unforeseeable risk factors, political interventions and broad economic crisis fall under the heading of investment manager risk.
The level of concentration and total risk that are proper in a given setting depend on various factors. For example, if a portfolio manager has a clear strategy to focus on the transportation sector with the full understanding that an oil price shock will hurt the portfolio badly, this lack of diversification may be fine. As long as investors understand the risks, and the investment manager is capable of riding the waves in the market skillfully, a 10% loss is not insurmountable. Great managers have recovered from bigger losses. Therefore, the risk and concentration in a portfolio should be evaluated within the proper context.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.