Module 6 · Concentration Risk Core

Concentration is the risk that produces both the best and the worst investing outcomes. This module is about knowing exactly how much of it you are carrying — including the concentration you did not choose and cannot see on your statement.

The base rate for single stocks

Before deciding how much of one company to own, it is worth knowing what happens to companies on average. The research here is consistent and genuinely surprising: the distribution of individual stock returns is extremely skewed. A minority of companies produce most of the market’s long-run gain, and the median stock does considerably worse than the index it sits in.

Hendrik Bessembinder’s work on US stocks since 1926 found that a majority of individual common stocks delivered lifetime returns below those of one-month Treasury bills, and that the entire net wealth creation of the US stock market over that period was attributable to a small percentage of listed companies. Later studies extending the approach globally reached similar conclusions.

Two implications follow, and they pull in opposite directions.

• Index investing works because of skew, not despite it. Owning everything guarantees you own the handful of extraordinary winners. Owning twenty names picked at random most likely means missing them.
• Stock picking is a skewed bet. If you concentrate, you are betting you can identify the minority. That is not impossible — but it means the honest default assumption for any individual holding is that it underperforms, and the position should be sized as though that is true.

Concentration inside index funds

“I own the index, so I am diversified” is true relative to owning five stocks and less true than most people assume. A market-capitalisation-weighted index owns more of a company as that company gets bigger, which means the index automatically concentrates into whatever has already gone up.

In recent years the top ten holdings of the S&P 500 have accounted for roughly a third of the index by weight — a level of top-heaviness at the high end of its historical range, and dominated by a single sector. An investor holding “the market” therefore has a materially larger bet on a handful of large technology companies than the phrase suggests. That is not a flaw in indexing; it is what capitalisation weighting means. But it should be a known position, not a surprise.

Two consequences worth internalising:

1. Your index fund gets riskier after a long bull run in one sector — precisely when it feels safest, because concentration has been rising the whole way up.
2. Adding a large-cap technology stock to an S&P 500 holding is doubling down, not diversifying. You already own it, at a meaningful weight.

Equal-weighted index funds exist as a partial answer, and come with their own trade-offs: higher turnover, a small-cap tilt, and a different set of periods in which they lag badly. The point is not that one is right, but that “index” is not a synonym for “diversified” without checking what is inside.

The Canadian problem

Canadian investors face a sharper version of this. The S&P/TSX Composite is heavily weighted toward financials and energy, with materials adding a further resource-linked slice; technology and healthcare are comparatively small. The exact weights move, but the shape has been stable for decades.

Stack the usual Canadian portfolio on top of that — a TSX index fund, a few bank shares, a pipeline, maybe a telecom — and the result is a concentrated position in Canadian interest rates and commodity prices, held by someone who is also earning Canadian dollars, likely owns Canadian real estate, and whose employment prospects depend on the same economy. The concentration is not just in the portfolio; it runs through the whole balance sheet.

The fix is unglamorous and effective: hold a meaningful allocation outside Canada. Module 7 covers the currency question that comes with it.

Employer stock

Employer shares deserve their own section because they are the concentration people most reliably underestimate. If your employer struggles you can lose your job, your bonus, the value of your unvested equity, and your investment — all at once, from one event. Your human capital and your financial capital are perfectly correlated, and the correlation only shows up when it hurts.

It is also the concentration most likely to be defended with genuine-sounding reasons: you know the company, you believe in it, the discounted purchase plan is free money. The first two are exactly the reasons employees of failed companies gave. The third is real — a purchase-plan discount is genuine compensation — but the correct response is to capture it and then sell, not to accumulate.

Hidden concentration

Beyond stocks and sectors, several concentrations do not appear as a line item anywhere:

• Factor concentration. Twelve holdings that are all high-growth, high-multiple, low-profitability names are one factor bet across twelve tickers. When that factor de-rates, all twelve go together, regardless of sector labels.
• Currency concentration. A portfolio of US-listed stocks is also a position in the US dollar. Module 7.
• Interest-rate concentration. Utilities, REITs, pipelines, telecoms and long-duration bonds are different asset classes with the same primary driver. A portfolio built for yield often turns out to be a single leveraged bet on the direction of rates.
• Customer concentration inside a holding. A supplier deriving half its revenue from one customer carries that customer’s risk. This is disclosed in the annual report and almost never in the stock screener.
• Correlation with your own income. Covered in Module 4, and worth repeating because it is the largest concentration most people have and appears on no statement.

Running a concentration audit

Do this once a quarter. It takes fifteen minutes and it is the highest-value fifteen minutes in portfolio maintenance.

1. By position. List every holding as a percentage of the total. Flag anything above your written cap.
2. By sector. Aggregate across individual stocks and the look-through holdings of your ETFs. This is where most people find a surprise.
3. By factor. Tag each holding: growth or value, large or small, profitable or not, rate-sensitive or not. Look for a tag that dominates.
4. By currency. What percentage of the portfolio is denominated in each currency, and does that match where you will spend the money?
5. By driver. The Module 4 test: write the one thing that would make each holding fall 40%. Count repeated sentences.
6. Including everything you own. Employer stock, pension, real estate, private business, and your income. The portfolio is not the unit of analysis — you are.