Having large exposure to one company makes your overall financial position very susceptible to the fortunes of that company. This is called ‘concentration risk.’
The fortunes of even the best companies can change, and it can often be caused by things outside their control.
Ryman is perhaps the most pertinent example; however, many companies have gone from ‘hero to zero’ in the past. We recommend investors limit their single company exposure to 10% of the portfolio (circumstances dependent) to reduce this risk.
Diversification is the only free lunch when it comes to investing. It has been proven over and over again, that the best way to reduce your risk when investing is to diversify your portfolio. Whilst exceptions exist, on average, diversification reduces your risk without having a negative impact on overall returns.
Concentration risk is not limited to investing in single companies, it also applied to geographies. This is why we recommend investors not limit their investments to New Zealand. A big shock, such as mad cow disease, would have a large impact on the New Zealand market (this was even seen with cyclone Gabriele, which saw the New Zealand market under-perform for a few weeks). This would see investors with overseas assets get double protection as their overseas assets would not be impacted in the same way as the local market, but they would instead benefit from the likely weakening of the New Zealand dollar, which would push up the value of their overseas asset in New Zealand dollar terms. Many South Africans would have benefited from having overseas exposure as their economy has faltered, and their currency weakened.
That is not to say we expect anything like that to occur in New Zealand, but the point of this entire article is that even the best performing companies and countries can come unstuck through unforeseen and poorly managed events.