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Overconcentration

Quite often a financial advisor will “fall in love” with a particular product and end up recommending it to all his clients in large quantities. This is even more so with private placements, especially Real Estate Investment Trusts (REITS) and Master Limited Partnerships (MLPs). This occurred to a group of our clients, all with the same broker who overconcentrated his clients in private REITs and MLPs. Private placements are generally not for most investors, but even for those that pass the necessary requirements to purchase these products, their exposure should be extremely limited. Simply because an advisor extolls the qualities of these particular products that appeal to you, does not mean he should recommend and place you in concentrated positions. As oil prices declined and commercial real estate became static, our group of clients suffered drastic losses due to the fact that their exposure was concentrated largely in two oil and gas sectors. These products did, at one point in time, pay a good return. However, the advisor in question forgot one of the most basic rules of investing, the need for diversification. This type of concentration is referred to as “sector concentration”, as the clients’ portfolios were almost 100% in only two sectors. When those sectors got hit, the clients took a big hit.

Concentration occurs in many situations. In a similar circumstance, an advisor was prone to recommending leveraged high yield bond funds. These type of bond funds are often referred to as “junk bonds”. Our clients, and many of his other clients, were heavily overconcentrated in these funds. The interest was compelling to the advisor. As such he vigorously recommended the products to our clients to the point that each client’s portfolio was more than 75% in the high yield funds. The recommendations were made notwithstanding the fact that every broker knows, or should know, that concentration is bad. This type of concentration is known as “product concentration” since most of the portfolios were overconcentrated in a particular product. If that product or similar products perform badly in the market, a portfolio that is not diversified and overconcentrated, will suffer as there are no other investments to balance out the portfolio.

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