As a general rule, it’s always wise to diversify your portfolio. This is a common message from wealth managers, and rightly so: diversification can help investors achieve a lower level of market risk for a given level of expected performance.
Unfortunately, many new clients that we meet aren’t taking a diversified approach to their investments; rather, the success or failure of their portfolio depends on the performance of a single stock position. This narrow focus creates what is commonly referred to as concentration risk, and it can threaten your long-term financial security.
In this short article, we’ll explore what motivates investors to hold a large single-stock position, as well as the advantages of diversification.
How Concentrated Positions Accumulate
It is tempting to dismiss a concentrated portfolio as the work of a DIY investor. After all, financial advisors are held to certain standards of care, so an investor with a responsible advisor would be discouraged from heavily concentrating their portfolio. However, concentrated stock positions can accumulate even in well-managed portfolios.
As it happens, investors most likely to find themselves in this position are current or former corporate executives who have received restricted stock or stock option grants, or have purchased stock during their tenure with a company. Executives with a concentrated position may have no choice but to keep that position until they leave the company.
Concentration risk can also accumulate in a portfolio through simple market appreciation. A portfolio that was 3% Apple stock in 2009 now likely has a significant Apple weighting. This is simply due to the fact that Apple stock has outperformed many other assets over the last 10 years. In other words, it is rare for an investor to take concentrated positions all at once; in fact, these positions are often not “taken” at all, but arrived at gradually over a long period of time.
Why Investors Maintain Concentrated Positions
Most investors recognize the need to diversify their holdings, yet despite the risks of a concentrated portfolio, they often hesitate to do so. Why?
The first reason is human nature. We favor the familiar over the unknown, even if the familiar may be riskier than the alternatives. This is known as familiarity bias, and it impacts every decision we make, from the route we take to work to our investments. Investors who are familiar with a company, whether as current or former employees or simply as longtime investors, often make favorable assumptions about its stock – even if all the evidence points to better or more stable returns being possible through diversification.
The second reason is capital gains avoidance. Many investors with concentrated positions accumulated them a long time ago with little to no cost basis; diversifying their portfolios means selling those assets, and the capital gains tax hit can be significant (potentially exceeding 30% for common stock in some states). Some investors are willing to bet that the amount they risk by maintaining a concentrated position is less than the cost of diversification.
Finally, concentrated positions can be a way for corporate executives to show that they have “skin in the game”; that is, they are personally invested in the success of the company.
Reasons to Diversify
When thinking about the why behind diversification, it can be helpful to consider the opportunity costs that come with a concentrated position. If your portfolio reset and you had its value in cash, would you construct the same portfolio? For most investors that are holding a concentrated position, the answer is no.
Research also supports the move toward diversification. A study from JP Morgan looked at the performance of individual stocks within the Russell 3000 between 1980 and 2014. During that time period, 40% of stocks suffered a “catastrophic decline” – losing at least 70% of their value and never recovering. Just as important, the median stock price underperformed the overall index by 54%.¹ This shows that while there are stocks that outperform the market over the long-term, there is significant risk in holding a concentrated position.
Lastly, there are emotional benefits to diversification. Market swings are an inevitable part of investing, and we’ve seen that periods of volatility can be more stressful for clients with concentrated portfolios. We’ve used the analogy that diversifying your portfolio is like getting an oil change: in all likelihood, nothing will happen in the short term if you don’t, but the risk increases over time. Taking care of it means there’s one less thing to worry about.
How We Can Help
If you are holding a concentrated position and want help diversifying, we invite you to connect with our team. Our first step will be to determine the capital gains tax impact of any decision, and what strategies exist to minimize this impact.
ABOUT THE AUTHOR: Jeff Fosselman, CPA, CFP®, JD
With more than a decade of experience in the industry, Jeff Fosselman is instrumental in delivering financial planning strategies and counsel to high-net-worth individuals. As Senior Wealth Advisor for Relative Value Partners, Jeff provides comprehensive advisory services in estate planning, income tax planning, cash flows, asset allocation, and strategic philanthropy.
Information contained in this article is obtained from a variety of sources which are believed though not guaranteed to be accurate. Past performance does not indicate future performance. This article does not represent a specific investment recommendation.
No client or prospective client should assume that the above information serves as the receipt of, or a substitute for, personalized individual advice from Relative Value Partners, LLC which can only be provided through a formal advisory relationship. Clients of the firm who have specific questions should contact their Relative Value Partners counselor. All other inquiries, including a potential advisory relationship with Relative Value Partners, can be directed here.