BROKER MISCONDUCT: OVERCONCENTRATION
Overconcentration is a failure to adequately diversify securities within an investment account or portfolio, exposing it to extreme levels of risk. In plain English, it’s what happens when you put all your eggs (money) in one basket (type of security, asset class, commodity, or industry).
Overconcentration occurs when investors and/or financial advisors ignore the need for diversification or balance within a portfolio to make it more resilient against the vicissitudes of the stock market.
Investors overconcentrated in tech stocks when the dot-com bubble burst in March 2000 know exactly what this means and how it feels. Similarly, those who funneled more and more of their money into the financial services sector and/or real estate sector before the subprime mortgage crisis of 2008-2009 have felt the pain of overconcentration.
What Causes an Investment Account to Be Overconcentrated?
Overconcentration generally springs from two key sources: ignorance and naivete, sometimes both at once. Depending on the outcome of the overconcentration, it may lead to legal action through the Financial Regulatory Industry Authority (FINRA)’s arbitration process. Unsophisticated investors who buy up too much of one type of financial product or too many securities in one sector of the economy can be excused for overconcentrating their portfolios due to ignorance or naivete.
Many casual investors don’t understand the value of balance within an investment account until they’ve been wiped out once already. Or if they did provide for diversification when they first structured their portfolio, they become guilty of the old “too much of a good thing” problem, which sees them purchasing more and more of whichever securities are giving them the highest or most consistent earnings.
Now, of course there’s nothing wrong with wanting to increase your stake in a winning company or hot sector of the economy. But investors must also always keep in mind that buying too much can render your portfolio as a whole lopsided and vulnerable to sudden changes of fortune in the notoriously fickle market.
Overconcentration May Be the Result of Negligence by Your Financial Advisor
When a financial advisor or stock broker overconcentrates a client’s portfolio, we enter the realm of negligence. FAs and brokers often overconcentrate accounts for the same reasons investors do. Everybody loves a winner, and especially a winner that appears to be undervalued or is throwing off high rates of return. But each investor has a unique investor profile, constituted by their investment objectives, risk tolerance level, and life situation.
Theoretically, one man’s overconcentration could be another man’s balance. Practically-speaking, however, a healthy and well-balanced portfolio will be composed of a mix of securities that effectively spread out financial risk. Naturally, it’s possible to mitigate risk using just one type of security or one sector of the economy’s companies (for instance, you could invest in well-established, lower risk aerospace companies like Lockheed-Martin and at the same time in higher risk aerospace startups like Martin Aircraft Company, makers of the latest jet pack for human air propulsion). With so many financial products available to you, and so many sectors of the economy to choose from, however, it hardly makes sense to focus too narrowly on any one thing.
In our experience with legal claims centering on issues of overconcentration, we also find that investors or financial advisors are unaware of underlying overconcentrations within a single portfolio. For instance, certain complex financial products like alt funds and variable annuities are made up of numerous subaccounts which are invested in any number of different products, from the most common to the most exotic. But if, say, your variable annuity subaccounts are invested in equities, while the rest of your investment account consists exclusively of equity holdings, and you’re an investor who doesn’t love risk, well, even though you’ve got stock and a variable annuity, which may seem different enough to signal a decent level of diversification, in fact what you’ve really got is a whole lot of equity. And risk. In other words, you’ve got overconcentration.
Overconcentration: Investor Profiles and Risk Tolerance
Ultimately, overconcentration refers back to the individual investors’ risk tolerance and profile. While it’s always objectively a good idea to seek diversification in an investment portfolio, the issue, especially when it comes to securities litigation, is whether one specific account has been diversified sufficiently for one specific investor. There are no universal rules, really. Just rules of thumb. Which brings us right back where we started with “don’t put your eggs in one basket,” especially not your nest-egg!
PA & NJ Broker Misconduct Lawyers
Our securities attorneys have over a decade of experience helping retail investors recover losses from stock brokers and national brokerage firms. We understand complex financial products and appreciate how stressful losing your wealth to an unscrupulous or negligent advisor can be.
If you or anyone you know has been the victim of investment fraud or broker misconduct, please contact us immediately for a free consultation at 215-462-3330 or by using our online contact form.