Concentration Risk: Our Apple Call

Posted on December 12, 2012 at 7:35 AM PDT by

Let’s talk concentration risk: If you’ve checked on your portfolio in the last few months, you might have noticed a certain deflating feeling centered around a single stock.

As we pointed out several months back, it would be only natural for the big mutual funds to begin to sell their holdings in Apple (AAPL).

concentration risk

Soon enough, that’s precisely what happened. We argued then that shorting the stock would make a perverse kind of sense to at least part of the trading universe, thus sinking the tech giant. It’s down almost 19% since that date.

Of course, shorting is a silly risk for retirement investors and not a course of action we would recommend. (Our article instead made the case that passive investors who steadily rebalance have been selling Apple all the way up, reducing their risk.) And, believe us, we’re not here today to make any kind of argument that it’s time to get back in.

Suffice it to say we’re as shocked as anybody at the timeliness of Apple’s fall in regard to our highly qualified short call. We could have made 10 other calls in late September that were horribly wrong. That’s why we rarely talk about specific strategies at all.

No, for the retirement investor, the salient point about Apple stock, or any other perfectly good large cap, be it Exxon Mobil (XOM), AT&T (T) or any of the banks or giant manufacturers, is precisely the problem of concentration risk.

Kevin Kelleher wrote a spot-on analysis of the problem at PandoDaily, the Silicon Valley news site. Apple’s decline is not about new CEO Tim Cook, the miniaturized version of the iPad, the absence of Steve Jobs or the weather patterns over Cupertino.

It’s about too many investors betting the farm on one stock. Here’s the salient point from Kelleher:

Fund managers don’t like having too high a percentage of their holdings in a single company, even if that company is Apple. They diversify to limit the risk of one company tumbling. Because, should Apple’s stock start to drop, it has a disproportionately large effect on their fund’s performance. And Apple’s stock is dropping.

Imagine you are a hot fund manager. You’ve had a splendid run over the past several years. Your flagship is up double-digits and investor money is pouring in. Nobody is even breathing the dreaded “R” word (redemptions).

Being an active trader, you suffer from a chronic and lifelong case of confirmation bias. That is, you have come to believe that things go your way because you’re right. It’s not chance, not favorable government policy, not foreign capital seeking risk, not even earnings or fundamentals.

Nope, you’ve got confirmation bias bad. At this stage of the game, increasingly you’re right simply because you’re right. Like a basketball player with a hot hand, you sink shots because you take them. So you keep taking shots.

Recognizing concentration risk in manic times

It’s easy to forget that you’re not the only player on the court and not even the only star. Lots of otherwise drab funds had great quarters lately thanks to the mania for all things Apple. It simply couldn’t last, could it?

Yes, Steve Jobs utterly changed the technology business. His product ideas, although not necessarily original, were so ruthlessly perfect in their execution that Apple stock deserved a premium, no question. Cook might be able to continue that legacy.

But a $1 trillion market cap? To get there, you need help. You need cheerleaders. And you need rampant confirmation bias to push you along.

Retirement investors could use great performance, but they shouldn’t accept pointless risk. If you wanted to roll the dice and have some fun, there are better ways to lose your money.