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The Risks of Overconcentration in Pot Stocks

The annals of investment history are lightly peppered with stories of ordinary people who made their millions concentrating their holdings with a single company—Microsoft, Sears, Facebook, and others. However, these success stories are the exception, not the norm.

When the retirement nest egg is at stake, the risk of overconcentration in any single company stock, industry, or sector is a peril any investor should take seriously—as should their brokers. Unfortunately, advisors and brokers sometimes fail their investor clients in this regard. This form of blunder can result from a broker’s carelessness, intentional deception, negligent management, or malpractice.

What Is Overconcentration?

Overconcentration occurs when too much of an investor’s money is held in either one or too few stocks. A broker who builds portfolios around a single stock puts investors in a vulnerable situation. When that company, product, or sector declines, significant financial losses often follow.

Brokers owe their investors a duty to ensure that their portfolios contain investments in a variety of products across different asset classes and industries. This diversification should align as well with the investor’s investment objectives and financial circumstances.

The Financial Industry Regulatory Authority (FINRA) Rule 2111 establishes brokers’ and investment advisors’ responsibility to handle their customers fairly by honoring the tenets of reasonable-basis suitability, customer-specific suitability, and quantitative suitability. Some brokers fail in this capacity, recommending that an investor place a disproportionally large amount of the investor’s assets in a single stock, industry, or sector.

When such investments backfire, it’s the investors who lose.

We’ll focus here on two areas where we see overconcentration as being an especially notable concern: pot stocks and single-stock exchange-traded funds (ETFs).

Pot Stocks

Cannabis stocks are a shining example of a market sector that has beckoned recent overconcentration, with investors chasing elusive, high returns from a nascent industry. For some, putting all their eggs in the emerging marijuana industry basket promises high returns on investment, especially given pot’s changing legal status.

However, the Global Cannabis Stock Index, which has 26 names, has been on a steady downward spiral this year. By September 30, the index had 65.7% in 2022, according to New Cannabis Ventures. As of this date, the strongest of the 26 names in the Global Cannabis Index had performed as follows:

  1. Innovative Industrial Properties: Down 66.3% year-to-date
  2. Chicago Atlantic Real Estate Finance: Down 13.5% year-to-date
  3. Cronos Group: Down 28.1% year-to-date
  4. Turning Point Brands: Down 43.8% year-to-date

New Cannabis Ventures also reported year-to-date performance for the index’s four weakest names:

  1. Leafly: Down 93.2% year-to-date
  2. Ayr Wellness: Down 84.4% year-to-date
  3. Hydrofarm: Down 93.2% year-to-date
  4. Trulieve: Down 67.3% year-to-date

On October 6, 2022, cannabis stocks like Tilray Brands and Canopy Growth surged, according to CNBC. The uptick followed President Biden’s announcement of marijuana pardons. However, “Biden’s move does not change the business outlook for corporatized marijuana in the United States.” the news outlet reported.

Single-Stock Exchange-Traded Funds (ETFs)

July 2022 marked the introduction of the first single-stock ETFs. With these investments, traders gamble big on individual stocks. Single-stock ETFs are leveraged ETFs. Their performance is tied to an individual stock’s daily return. They are not long-term investments—and they are risky. In an interview with Nerd Wallet, Frank Pare, former president of the Financial Planning Association, warns that "… things can go wrong really quickly [with single-stock ETFs]" and that chances are good the funds' fees will "erode any positive returns."

Single-stock ETFs do not suit the average investor, especially those with a low tolerance for risk. When these funds launched in July the U.S. Securities and Exchange Commission (SEC) penned concerns for investors on the agency’s website.

"The daily rebalancing and effects of compounding may cause returns to diverge quite substantially from the performance of the, in this case, one underlying stock, especially if these products are held over multiple days or more," said SEC Commissioner Caroline Crenshaw.

“Because of the features of these products and their associated risks,” Crenshaw added, “it would likely be challenging for an investment professional to recommend such a product to a retail investor while also honoring his or her fiduciary obligations or obligations under Regulation Best Interest.”

The Importance of Diversifying an Investment Portfolio

Both FINRA and the Securities Exchange Commission see allocation and diversification as vital elements in a sound portfolio, according to Patrick Barrett, of Levin Papantonio Rafferty’s Securities and Business Litigation.

“Research indicates that asset allocation drives more than 90% of an investment portfolio’s performance,” Barrett said. He further explained that different asset classes exhibit different behaviors.

“When bonds go down, stocks typically go up,” Barrett said, adding that different asset types (stocks, bonds, and cash), as well as a variety of industry sectors medical, technology, and energy) make up a balanced investment portfolio. “Similar to asset classes, investing in different industry sectors keeps the portfolio balanced because different sectors are not influenced by the same factors,” Barrett said. “They do not move up and down in tandem.”

Investors can mitigate risks without sacrificing returns when they include each industry sector in their portfolios, Barrett explained.

Securities Fraud and Arbitration Lawyers

Diversification of funds is one of the fundamental principles of investing—and any broker or financial advisor should know this.

Registered brokers and financial advisors have a duty to inform themselves of key facts about their investors—their age, investment risk tolerance, and financial status--when making investment recommendations. Furthermore, these professionals have an obligation to give their investor clients the information required to make informed decisions.

Investors should know they have rights when their financial professionals or broker-dealers are fraudulent or negligent in recommending or allocating an overconcentration of assets that does not match the investors’ investment goals, income level, financial obligations, and/or other factors.

An investor who finds they have suffered financial losses in such a situation can contact a securities fraud and arbitration lawyer who can work to hold the broker or their brokerage firm accountable for these losses.