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What is Concentration risk in Equity funds?

Have you heard of the saying “putting all your eggs in one basket”? It means that you are dedicating a large number of your efforts and financial or other resources to one thing and hoping for its great success.

Similarly, in your investment portfolio, your eggs are your savings – the money bags and the sectors or themes or instruments are the baskets.

When you put all your eggs in a particular sector, and if the market crashes down due to unforeseen market conditions, all your eggs go bad (in short – you lose all your money bags). This is a concentration risk.

When you have invested a lot in a sector, most of your expected returns depend solely on that particular sector’s performance. The possibility of your returns getting derailed due to high dependency on a small set of factors – this unique risk is called concentration risk.

Why is this risk important?

When we invest, we invest for our future, and our long-term goals – retirement, children’s education, wedding expenses, and more.

Suppose, you invest in a mutual fund that is supposed to earn you a 15% return. However, if the mutual fund invests only in the infrastructure sector – this fund could be impacted by a multitude of macroeconomic factors such as interest rates, price of fuel, currency appreciation/depreciation, etc.

In the time period of 2007-12, the infrastructure index gave an annualized return of -3% when compared to Nifty, which earned its investors a return of 7-8%.

This is when diversification becomes important. Your portfolio should consist of sectors that complement one other.

For instance, when oil and gas prices are on the rise, the energy sector is outperforming the market. However, the infrastructure sector which uses energy as input, or any sector which utilizes oil and gas as an input in their production would see an increase in costs – a decrease in stock price.

Hence, these would move in opposite directions. If you had stocks from sectors that are moving in the opposite direction, you would either benefit from the net upside (Sector 1 increase + Sector 2 decrease), or you would limit your downside.

Some sectors such as steel have long business cycles – they tend to have a longer slump (of greater than 10 years) due to macroeconomic conditions such as lower demand or higher supply, etc. If one invests in these sectors, there is a high risk of your portfolio underperforming the market.

Consider a fund that invests in oil, steel, and other metals (they are also available as commodity indices). Oil and metals typically see simultaneous ups and downs in market cycles – this would mean higher risk and a higher impact on the portfolio of the fund.

Marco-economic correlation

Debt funds are impacted by a change in interest rates. When the RBI policy announces an increase in interest rates, the prices of the funds start to plummet if they have invested in long-term bonds (which are impacted the most).

Similarly, there could be sectors that are impacted by interest rate movements or GDP movements. When there is a declaration of a decrease in interest rates by RBI’s monetary policy, NBFCs could gain from this move.

The banking sector could be affected by this move due to a crunch in the interest margin i.e., profit for the bank – as the interest rates climb up, the profit margin increases and vice versa.

However, this could also mean that the banks are able to borrow from the RBI at a cheaper rate. Large companies with stable cash flows will find cheaper debt financing options, and hence their stocks could also be on the rise.

Hence, if one had only invested in the Banking and Financial sector (BFSI), one would see a drop in their portfolio. When there is an increase in interest rates and if one had invested in the Auto and Real estate sectors – despite having invested in two sectors, the impact would be negative.

Beware of these correlations and invest in sectors that are least similar, so that your eggs cushion your portfolio during economic volatility.

Consult an expert advisor to get the right plan

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