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:
Loyalty to company: It is only natural to feel loyal toward a company or stock that has made you a lot of money. That loyalty is likely magnified if you were or are a long-time employee of the company. In the event of a significant downturn, you may receive a double whammy if you are still working at the company, as your job and your stock’s value could both be at risk. This is the main reason we rarely recommend buying much company stock in your 401(k).
Loyalty to family: If you inherited the stock from a relative, you may feel you are going against their wishes if you sell it. After all, “It did so well for Mom and Dad.” That emotional tie can be very strong. However, we suggest diversifying that position would do more to protect the wealth you inherited than continuing to hold the stock. Just last week, the father of one of our clients told us his philosophy: “Concentrate to make money and diversify to keep it.”
Belief the company will continue to do well: After all, it’s always done well! This overlooks that fast-growing companies usually slow down, and strong, mature companies can stagnate, become obsolete due to changing technology, or make cripplingly bad decisions.
Belief the company will bounce back: In the event of a dip in a concentrated position, we have seen investors want to wait until the stock comes back because they don’t want to sell below its prior high. Sometimes they wait forever; however, if it does bounce back, their belief shifts back to the previous point.
The tax hit: Rarely do we see concentrated positions in a tax-advantaged account. Most investors know that it is not wise to put all of your eggs in one basket or own too much of any one stock. However, if selling $500,000 (cost basis $100,000) of General Electric means paying an additional $100,000 in taxes, well, that is a lot of reasons not to sell GE!
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:
Sell (or trim) and reinvest: Though we believe the sooner one diversifies out of a concentrated position the better from a portfolio performance and risk standpoint, we realize that it is difficult to absorb such a large tax hit in one year. We usually recommend spreading the gain out over a few years, depending on the size of the gain. We look to realize losses elsewhere in the portfolio wherever possible to minimize net realized gains in the portfolio.
Charitable gifts: If you are charitably inclined, donating part of your concentrated stock is an excellent way to fulfill your charitable intentions. We recommend doing this instead of writing a check, as you can remove the tax burden from the shares gifted.
Hedge the position: There are several ways to hedge a concentrated position. Hedging can be costly, and you still retain the concentrated position. We rarely suggest hedging, though it may make sense if a step-up in cost basis was imminent, and you could wait until the shares were bequeathed to heirs to sell or trim the stock.
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.