Overconcentration: The Risks of Concentrated Stock Positions
Overconcentration, or “failure to diversify,” is a type of financial misconduct. It occurs when a broker concentrates an investor’s account in one particular investment, class of investments, or market segment, to the point that this concentration exposes the investment portfolio to an inappropriate degree of risk. If an investor loses money due to overconcentration, they should contact a securities attorney to evaluate their case and determine if they may be entitled to a FINRA arbitration award.
When an account is overconcentrated, the price movement of the security (or market sector) could cause huge losses in the investor’s portfolio. For example, if an investor over-concentrates their portfolio in oil and gas investments, their portfolio could rapidly lose money when something like a global pandemic drives down the price of oil. Or an investor could be invested in only one type of security, like common stock, rather than a mix of stocks and bonds. Stocks are riskier than bonds and should only make up one part of a comprehensive investment strategy.
Overconcentration is the opposite of diversification, one of the fundamental principles of investing. To avoid the risk of concentrated stock positions, financial professionals should recommend a variety of investments, including stocks, bonds, mutual funds, and exchange-traded funds.
Is Overconcentration Always Against FINRA Rules?
FINRA Rules require that a broker only recommend suitable investments to their clients. Overconcentrating a client’s portfolio in a security or area of the market could be deemed unsuitable for the investor. Investors should review their holdings to determine if their advisor recommended an overconcentrated portfolio.
FINRA describes five basic types of concentration:
- Intentional concentration. An investor may have intentionally invested in one type of asset as a personal preference, based on their belief that the investment will perform well in the future.
- Concentration due to asset performance. One investment may have performed so well that it now represents a much greater percentage of an investor’s portfolio than it did before. Investors should always be aware that past performance does not necessarily predict future performance
- Company stock concentration. Employees might want to invest their retirement in their company’s stock. FINRA warns against the dangers of holding too much company stock. Company loyalty should not detract from a sound investment strategy.
- Concentration due to correlated assets. Investors might fail to diversify their portfolios by concentrating on investments in the same industry or geographic location. For instance, if you buy a lot of Apple stock and purchase a technology Exchange-Traded Fund (ETF), you are running the risk of losing money if the technology sector takes a hit. FINRA advises that you “look under the hood” of any ETF investments to ensure that these funds will help diversify your portfolio rather than offer more of the same type of stocks you already own.
- Concentration in illiquid investments. This is particularly risky, especially for investors buying securities with money they might eventually need. Certain investments, like non-traded Real Estate Investment Trusts (REITs) and unlisted Direct Participation Programs, expect their investors to hold the investment for a long time. These investments may be tempting because of their potentially high returns, but investors who have to cash out of their illiquid investments will have to pay exorbitant fees and could still wait an extended period to access their funds.
How Does FINRA Define Overconcentration?
FINRA Rule 2111, also known as the suitability rule, defines overconcentration. This rule requires brokers to investigate investment attributes, including benefits, risks, tax consequences and other relevant factors, to form a reasonable basis for an investment recommendation. “Suitability” encompasses suitable strategies as well as suitable investment products. Overconcentration is not a suitable investment strategy for most investors since it comes with unnecessary risks.
Brokers must consider their investor’s investing experience, age, financial goals, and risk tolerance before recommending an investment strategy. If an investor relied on their broker for recommendations, and the investor can demonstrate that their broker did not warn them of the risks of overconcentration, a FINRA arbitration panel may find that an investor is owed an arbitration award.
Example of Overconcentration
FINRA regularly reviews arbitration cases that allege unsuitable, over-concentrated investment recommendations.
For example, on July 30, 2021, an investor alleged that their broker over-concentrated their portfolio in high-risk investments. According to the BrokerCheck disclosure, these high-risk investments included Cottonwood Residential, Carter Validus Mission Critical REIT, and GPB Automotive.
- GPB Automotive is part of GPB Securities, which was recently labeled a Ponzi scheme by the SEC and the FBI. Many investors have alleged their brokers did not conduct their due diligence when they recommended shares of GPB and should have known that the investment was at least high risk, if not outright fraud.
- Carter Validus Mission Critical REIT, which now does business under the name Sila Realty Trust Inc., is a non-traded Real Estate Investment Trust (REIT), an especially risky type of investment. “Non-traded” means that it is not publicly traded on a stock exchange, which limits the amount of publicly available information. This makes it more difficult to evaluate the company’s business model and strategy.
- Cottonwood Residential recently merged with Cottonwood Communities, another non-traded REIT.
Concentrating on so many high-risk investments is unsuitable for most investors. The investor is seeking $231,000—as of January 12, 2022, the dispute is pending.
Why Do Brokers Ignore the Risks of Concentrated Stock Positions?
Your broker may have believed that a high-risk investment would pay off eventually, but they should still take your risk tolerance into account when they recommend an investment. In some cases, brokers might not be motivated to inform their investors of the risks of concentrated stock positions because of the high broker commissions that come with the transactions. (Investors have alleged that brokers who recommended shares of GPB Capital may have been motivated by especially high commissions.)
What Should I Do Now?
If you believe your portfolio lost money because of overconcentration, you should contact a securities attorney. A securities lawyer can help you decide if you have a case and what steps you should take to prepare for FINRA arbitration—the process most investors must undertake if they wish to recover investment losses. Get in touch with the securities attorneys of Kurta Law for a free case evaluation today: Call 877-600-0098 or email email@example.com