3. Concentration you cannot see in the portfolio

Risk 7: The risk that is not in the prices

Level 2 taught you to discount size when several bets are, at bottom, the same one, and level 5 carried that idea across the whole portfolio: diversifying means spreading risk, not positions. This module looks at a different layer. The concentrations it deals with do not appear in any correlation matrix because they are not assets. They are the structure surrounding the portfolio: what it passes through, what currency it is denominated in, under which laws, on what information decisions are taken and what the salary of whoever manages it depends on.

A single intermediary

You can have twenty funds, five regions, four asset classes and one single point of failure. If everything goes through one broker, any event affecting that firm affects one hundred percent of your wealth at once: an insolvency, a temporary trading freeze, an IT problem lasting several days, a policy change forcing you to transfer everything, an administrative error that freezes your account while it gets sorted out.

This is not an argument for scattering yourself across six firms. It is an argument for asking the question explicitly, with a threshold in euros: above a certain amount, a second intermediary stops being a nuisance and becomes a risk decision, exactly like the maximum size of a position.

A single currency

A euro area investor who buys an unhedged index fund on the US market has two bets and usually counts one. If the index rises 10% and the dollar depreciates 12% against the euro, the result in euros is negative despite having been right about the market.

The question is not whether hedging the currency is a good idea, which depends on the time horizon and the asset. The question is that the exposure exists even though you did not choose it and even though your broker shows you the return in the product's currency.

The reminder of how far that risk can go comes from January 15, 2015. The Swiss National Bank removed without warning the floor of 1.20 francs per euro it had been holding since 2011. The euro at one point lost around 30% against the franc during the session, before settling on a somewhat smaller fall by the close. A British retail broker, Alpari UK, went insolvent within hours, and another one listed in the United States, FXCM, needed a rescue loan of some 300 million dollars to stay open. A currency regarded as boring moved in one day what a stock market moves in an entire crisis.

A single country, in the legal and tax sense

Holding your portfolio in a single country is not just a market bet. It drags a complete package along with it: the tax regime for capital gains, withholding taxes at source on dividends, reporting obligations, inheritance treatment and the possibility of any of those pieces changing through a law passed without anybody asking you.

The most concrete and worst understood example is inheritance. A Spanish resident who buys shares and exchange-traded funds domiciled in the United States is acquiring assets which, for inheritance purposes, are treated as situated there, with a very small exempt threshold for non-residents unless an applicable treaty exists. The same exposure to the same index bought through a product domiciled in Ireland drags no such problem along. Nobody discovers this by reviewing their returns.

A single source of information

If your whole process, prices, sector classifications, screens and comparisons, comes out of a single source, that source is an undeclared position in your portfolio. When it changes methodology, reclassifies a sector, stops offering a piece of data free of charge or simply goes down for two days, your judgment is left with no floor under it. Index providers reclassify countries and sectors from time to time, and those decisions move real money.

A salary correlated with the portfolio

This is the largest concentration of all and the one fewest people work out, because the asset is not at the broker: it is the job. Your capacity to generate future income is usually worth more than your portfolio, and it has a specific correlation with the market.

• Employment in the financial sector, portfolio in banks. When the banking crisis arrives, the job, the bonus and the portfolio fall together.
• Pay in shares of your own company. The asset and the source of income are literally the same thing.
• Your own business tied to the cycle. Construction, advertising, consultancy, restaurants: in a recession the business's cash and the portfolio go down together.
• Stable employment unrelated to the cycle. Here the opposite holds, and it reasonably supports more risk in the portfolio at the same tolerance.

The practical consequence is an uncomfortable one: whoever knows a sector best is the person who should concentrate in it least, because their knowledge and their exposure come from the same source.

A real case: the Enron employees

In the late nineties, Enron's occupational pension plan had a very dominant share of its assets invested in shares of the company itself, of the order of sixty percent, between company contributions made in shares and voluntary decisions by the workers. The share was performing excellently and it was the investment all of them believed they understood better than anybody.

Between 2000 and the end of 2001 the share went from over eighty dollars to practically zero, the company filed for bankruptcy and some twenty thousand employees lost their jobs. The accumulated retirement savings that evaporated are put in the billions of dollars. There was no failure of diversification by sector or by geography: there was a single exposure, the company, repeated in the salary, in the pension plan and in the personal portfolio. No risk measure computed on prices would have shown that concentration, because it was not in the prices.