One of the most common investment risks for successful individuals and families is not necessarily owning the “wrong” investment. It is owning too much of one investment—or having too much of your financial future depend on one source of wealth.
Concentration can happen gradually. A company employee accumulates stock through RSUs, stock options, or an employee stock purchase plan. A business owner has most of his or her net worth tied to the company. A successful real estate investor purchases several rental properties, but all of them are located in the same geographic area.
If something goes wrong with that one company, one industry, one real estate market, or one economic region, a large portion of your wealth can be affected at the same time.
Equity Compensation Can Create a False Sense of Wealth
Equity awards, such as company stock options, employee stock purchases, can be extremely valuable, but they can also create a psychological challenge.
When a company’s stock has performed exceptionally well, employees may become reluctant to sell because they believe:
“I’ve worked hard for these shares, and I don’t want to give up the upside.”
That instinct is understandable. But once an award has vested, the question changes. You are no longer deciding whether you want to receive the stock. You are deciding whether, if you had the cash today, you would voluntarily use it to purchase that same amount of your employer’s stock.
That is a very different question. If the answer is no, it may be worth examining whether continuing to hold the shares is consistent with your overall financial plan.
The goal is not necessarily to sell everything immediately. The goal is to determine how much company stock is appropriate relative to your total financial picture, risk tolerance, future compensation, tax situation, and financial goals.
Real Estate Can Create Concentration Risk Too
Real estate is often viewed as a diversification strategy because it is different from stocks and bonds. But owning real estate does not automatically mean that your wealth is diversified.
Consider a family that owns:
- Their primary residence
- Three rental properties
- A vacation property
- An office or commercial property
If all of those properties are located within the same metropolitan area, the family’s real estate portfolio may be highly concentrated geographically.
Suppose an investor owns $3 million of rental real estate in one metropolitan area. The investor might consider the portfolio diversified because it consists of five different properties. But all five properties may depend on the same local economy:
A major employer leaving the area could affect employment, housing demand, rents and property values.
A significant change in local regulations could affect landlords.
A prolonged period of population decline could weaken demand.
A natural disaster could affect multiple properties simultaneously.
Five properties do not necessarily mean five independent investments. The properties may have different addresses, different tenants, and different purposes. But they can still be exposed to many of the same economic forces.
Even changes in property taxes, insurance costs, zoning rules, infrastructure, or local economic conditions can affect several properties at once.
If a significant portion of your wealth comes from employer stock, equity compensation, a privately owned business, or real estate concentrated in one geographic area, it may be worthwhile to look at your holdings as a single integrated balance sheet rather than evaluating each investment separately.
The important question is not simply, “Is this a good investment?”
It is:
“How much of my financial future depends on this investment continuing to work?”
