Many of our clients have accumulated substantial wealth in their lives. Often that wealth can be attributed to a few stocks that have done extremely well over many years. As a result, it can be very difficult for these clients to transition their concentrated positions (5% or greater of their investable net worth), which have treated them so well in the past, into a diversified portfolio. However, investment research has shown that a diversified portfolio of stocks will usually outperform a concentrated position over time while experiencing significantly less volatility.
Nevertheless, frequently investors are hesitant to sell their concentrated positions. Here are some of the most common reasons:
Though these feelings are understandable, the reasons to diversify a concentrated position are compelling. Quite simply, a single stock is significantly riskier than the overall stock market. According to a Bessemer Trust study, on average, a single stock is nearly twice as volatile as a diversified portfolio (defined as 30 or more stocks). In addition, the study found that over 65% of the stocks that were in the S&P 500 from 1990-2012 experienced a maximum loss greater than that of the index. A study by Cambridge Associates found that a 75% single stock/25% municipal bond portfolio had a 41% probability to lose at least 25% of its market value in a given five-year period compared to only a 13% probability of that loss in a 75% diversified equity/25% muni bond portfolio.
Behind every concentrated stock position is usually a great success story about when it was purchased and how much it has grown. That’s how it became such a large position in the portfolio! However, for every name that is a recent success story (Facebook, Amazon, Netflix and Google), there are former success stories that have been hit hard. One example this year is GE, which is down 40% in 2017 compared to the S&P 500, which is up over 20% during the same period. Another example is Equifax, which saw its stock price fall by 35% during a six-day stretch in September (the S&P 500 was up during the same period).
How should investors go about diversifying a concentrated position? Here are three possibilities:
Take the Right Amount of Risk and No More: At Bragg Financial, we are proponents of owning a well-diversified, low-cost portfolio that is invested with an appropriate level of risk given a client’s age, need for growth/income and risk tolerance. We advise clients to take only as much risk as they need to in order to meet their goals. Why take more risk than is required to meet your goals? A typical Bragg large cap equity portfolio is made up of approximately 60 stocks. We also own diversified mutual funds and/or ETFs in the mid cap, small cap and foreign equity asset classes. In a $3,000,000 portfolio, invested with a 70% equity/30% fixed income allocation, a typical large cap position size is $23,100, or less than 1% of the portfolio. Thus the poor performance of a single stock cannot badly damage your portfolio.
The Clean Slate: This little exercise re-frames the question and has proven to be very helpful to those clients with over-concentrated positions. If you had $3,000,000 in cash today and were building the ideal portfolio, one designed to best help you reach your financial goals, how would you invest it? Would you invest 10% or more in a single company? If your answer is “no,” then you are probably ready to talk about how we can help. Thank you for your confidence in Bragg Financial. We look forward to helping you make good choices with your planning and investment decisions.
This information is believed to be accurate but should not be used as specific investment or tax advice. You should always consult your tax professional or other advisors before acting on the ideas presented here.