Concentration risk is something every investor needs to be mindful of. It can materially increase the overall risk of a portfolio and potentially undermine future returns. As retirement draws closer, the focus should arguably shift towards lowering portfolio risk, while still positioning investments to deliver strong long-term returns.
What is concentration risk?
Portfolio concentration occurs when too much of your total wealth is tied to a single investment asset, such as a property, shareholding, business, sector, or geographic market. That increases risk because the performance of your overall portfolio becomes too heavily dependent on that one exposure.
In A Random Walk Down Wall Street, Burton G. Malkiel argues that short-term investment returns are unpredictable and often lack any reliable pattern. That is exactly why diversification matters.
The real benefit of diversification is that it helps smooth returns over time. By spreading your investments across different asset classes and markets, you reduce your reliance on any one investment performing well. Over the next 12 months, some investments will perform strongly, and others may not, but together they can help stabilise both the capital value of your portfolio and the returns it generates.
Why the issue is not just returns, but dependence
Some investors may have significant concentration risk in their portfolio, but the more important question is whether that concentration actually matters. In other words, how dependent are they on the short and long term performance of those concentrated assets?
Take someone in their 30s who is just beginning their investment journey. At that stage, it is common for most of their wealth to be concentrated in a single investment property, particularly when their super balance is still relatively low. On paper, that may look like high concentration risk, but in practice it may be entirely appropriate. In fact, if the asset is high quality, it may well be the most effective structure at that stage of life.
Another example is a client I worked with a few years ago who had a substantial holding in CSL. They had inherited the shares from their parents, who originally bought them when CSL listed in 1994 at $2.30 per share. As a result, the client was sitting on a very large, unrealised capital gain. When I financially modelled their position, I assumed the CSL shares were worth nothing and still found they had more than enough assets to comfortably fund their retirement. That meant the future performance of CSL, while certainly relevant, was never going to put their retirement at risk.
Our three-step “concentration risk” framework
When clients first come to us, sometimes a large portion of their wealth is tied up in one or two assets. This often occurs when they have inherited direct shares from their family, and often those holdings carry significant unrealised capital gains, as in the example above. In these situations, we generally apply a three-step process to determine the best way to manage that concentration risk.
Step 1: assess future return, risk, liquidity, and opportunity cost
The first step in the process is to form a view about what the future may hold for the asset. It is important not to be overly influenced by past returns. The fact that there is now a concentration issue often means the asset has performed extremely well historically, which is why investors can be reluctant to make changes.
However, the real focus should be on what the asset is likely to deliver from here, not what it has delivered in the past. We need to assess its expected return over the short, medium, and longer term, having regard to its underlying fundamentals and overall quality. This helps determine the role the asset can realistically play in supporting future financial and lifestyle goals.
Beyond expected returns, there may be several other factors we also need to consider:
- the level of volatility and risk – what could potentially go wrong with this asset?
- how predictable the asset’s income and any related expenses are
- the liquidity of the asset, which affects our ability to respond if circumstances change
- whether the asset is geared and, if so, whether that gearing remains appropriate
The other matter we need to consider is opportunity cost. In other words, if we sell down the investment, what will we do with the proceeds? Will the funds simply be held in cash because that is the most appropriate strategy for the client’s circumstances? Will they be used to reduce debt – deposited in an offset account? Or will they be reinvested into other growth assets?
That matters because the decision to sell should not be assessed in isolation. It needs to be compared against the return, flexibility, and strategic value of the alternative use of that capital. Understanding the opportunity cost gives us the context we need to properly assess whether continuing to hold the asset is still the best option.
Selling down a concentrated direct shareholding also creates the opportunity to reinvest those funds in a more evidence-based way. For example, the proceeds might be redeployed into a rules-based, low-cost index portfolio that is better diversified across companies, sectors, and markets. That can help reduce portfolio risk and, arguably, improve long-term expected returns by relying less on the outcome of a single stock.
Step 2: test how dependent the financial plan is on the asset
The next step is to assess how dependent the plan is on the performance of that asset to achieve your financial and lifestyle goals. There are several important questions to work through.
- What happens if the asset underperforms for 5 to 10 years?
- What happens if the income from the asset falls?
- What happens if the asset declines materially just before a key life event?
- Does failure of this asset simply disappoint the plan, or does it break the plan?
- Is the client’s employment or business income also exposed to the same risk?
If underperformance of the asset puts retirement in jeopardy, creates unnecessary stress, or undermines financial security, then it may be necessary to make changes regardless of the expected future return, capital gains tax consequences or other considerations. But if the asset’s performance is unlikely to materially affect any of those outcomes, then the issue becomes one of optimisation rather than something that must be corrected.
Step 3: compare the cost of action versus the cost of staying exposed
The third and final step is to assess what it would cost to exit or reduce the position and compare that to the cost and risk of continuing to hold it.
That analysis includes estimating the capital gains tax liability based on today’s value, and also considering whether there are ways to reduce or better manage that liability. This might include making carry-forward concessional super contributions, using existing capital losses, or even selling other assets that are currently in a capital loss position. We also need to consider whether the owner’s tax position is likely to change materially in the future. For example, once retired, their taxable income may be much lower.
There are two important points to make here.
First, investors should be careful not to overestimate the tax benefit of waiting until they are on a lower marginal tax rate before selling. In many cases, the maximum saving is less than $34,000, being the difference between paying tax on the first $190,000 of taxable income at lower marginal rates versus paying tax at the top marginal rate of 47%. That is not an insignificant amount, but the value of the investment could fall by far more than that while waiting for a better tax outcome.
Second, many investors become so fixated on the tax liability that it leads to inaction. Yes, selling an investment and crystallising a large capital gain may trigger a significant tax bill. But choosing not to sell can be even more costly if the asset then falls materially in value. That is why the tax liability and the future return outlook for the investment both need to be considered and given equal weight.
For example, prior to 2025, we took opportunities to progressively reduce large client exposures to CSL when the share price rose above $300 per share. That did trigger capital gains tax liabilities. But with the benefit of hindsight, paying some tax was a far better outcome than continuing to hold, as CSL is now trading around $140-150 per share. That’s not to say that it won’t rebound – it might – but regardless we are comfortable with our exit value.
The other side of this is just as important. If the asset continues to rise in value, the capital gains tax liability does not disappear. It only gets larger, and so does the concentration risk. In other words, avoiding a sale because of tax does not solve the problem. It simply delays it.
The best way to think about this is that tax is one cost of reducing or exiting a concentrated position, but it is not the only cost. A sound decision requires weighing all costs and risks under both options: continuing to hold or choosing to sell.
Other factors we may consider
Depending on the client’s circumstances, there may be other factors to consider beyond this three-step process. One example is the correlation between concentrated assets and other parts of the client’s financial position.
For instance, if a client holds a large amount of shares in the company they work for, that creates an additional layer of risk because both their income and wealth are tied to the same source. That is not ideal.
Liquidity may also be an important consideration. If a client holds most of their wealth in illiquid assets, it may be sensible to introduce more liquidity into the portfolio, and reducing the asset with the highest concentration risk may be the most practical way to achieve that.
What we do in practice
In practice, we will usually adopt one of three approaches.
The first is to materially reduce the concentration risk through substantial divestment. This is typically appropriate where we are concerned that continuing to hold the exposure could undermine the strategy, either because the future return outlook is less compelling or because the downside risk is too great. In some cases, that may mean exiting the position entirely.
The second approach is to reduce the exposure progressively over time. This may be suitable where we are comfortable that the concentration risk is unlikely to derail the long-term strategy, but we still believe it should be reduced to a more prudent level. For example, we might sell a fixed amount each month over the next one to two years until the exposure falls to a level we consider acceptable.
The third approach is more opportunistic. If the concentration risk is acceptable and we are relatively indifferent about whether it needs to be reduced immediately, we may instead choose to only trim the position when the asset appears to be trading above its intrinsic value. In the case of shares, that might involve setting a ceiling price and deciding to sell if the stock trades above that level. That ceiling would typically sit at the upper end of our estimate of fair value.
This approach allows us to take some risk off the table when the price is attractive, while also creating an opportunity to redeploy that capital in a way that improves diversification and reduces overall portfolio risk.
The common mistake is not having a clear strategy
By far the most common mistake is not necessarily doing nothing. It is failing to have an informed and well-considered strategy.
What we often find is that clients have not worked through the three-step process outlined above. As a result, they cannot clearly explain whether the concentration risk actually needs to be reduced, and if so, by how much.
The goal of investing is to achieve the highest possible return for the lowest reasonable level of risk. Holding too much wealth in one asset clearly increases risk.
Therefore, the real question is whether you are being adequately compensated for taking that additional risk. More importantly, is it even appropriate for your circumstances to be taking that level of risk in the first place?
These are the questions every investor must address.
