Concentrated Equity Positions: Perils and Approaches

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At Blair Hall Advisors, we've seen both clients and friends wrestle with the challenge of concentrated equity positions, so we put these thoughts together to share.

Perhaps it’s stock from your employer, the result of an inheritance, or an investment you’re particularly bullish about. Here we’ll explore the potential perils of and approaches to being concentrated—which, from our perspective, means holding one or more equity positions where each is more than a few percent of your total equities.

Common knowledge tells us diversification is best …

Diversification is a fundamental concept in investment management and portfolio construction. The concept is based on the idea that a diverse group of assets has the potential to achieve a higher return with lower risk than any asset taken in isolation. Diversification can help mitigate concentration risk, which is the risk of amplified losses from having a large portion of holdings in a single exposure.

Intuitively, diversification makes sense: Spreading your investment dollars around reduces the possibility that weak performance in a single stock will sabotage your entire portfolio. After all, even a relatively stable individual large-cap U.S. stock—like Caterpillar Inc., a household name commonly described as a ‘blue chip stalwart’—is more than twice as volatile as the S&P 500 Index, as measured by standard deviation. As of April 30, 2018, the five-year trailing standard deviation of Caterpillar Inc. was 22.4, versus just 9.9 for the S&P 500. If you owned shares of Caterpillar Inc. during the last five years, you experienced greater fluctuations in returns than if you owned the diversified basket of U.S. stocks represented by the S&P 500.

Even with diversification, markets have plenty of volatility. For example, for about 40 of the last 90 years, the S&P 500 went up or down by more than 20% in a single year. Why add even more intense swings by being concentrated?

… But what about the home-run potential of concentrated investments?

We realize that a small percentage of entrepreneurs and investors have become billionaires thanks to the success of a small number of successful stocks—think of Warren Buffett, Mark Zuckerberg and Stanley Druckenmiller. So why shouldn’t all investors make concentrated investments?

Concentrated investors are exposed to substantially more risk. In a widely recognized study, researchers found the average monthly standard deviation for concentrated portfolios was 4.5 percentage points higher than the standard deviation of diversified portfolios. The higher standard deviation of concentrated portfolios indicates notably greater variability in returns. Most important, the study indicated the increased portfolio risk offset the larger portfolio returns, meaning the concentrated portfolios had a worse risk-return trade-off. In other words, the risk is generally not worth it to be concentrated.

What do we recommend instead?

Instead, we advocate for humble attempts at out-performance for those of you who are investing to maintain and grow your life savings. A few ideas we suggest you keep in mind for your equities:

  1. Design your portfolio to complement and, in the long run, reduce your concentrated investments.
  2. Diversify globally instead of relying too much on U.S. markets only. Investing globally in the long run has roughly the same return potential—some would argue even more potential—than U.S.-only, yet with notably reduced risk.
  3. Use evidence-based investing, to rely on Nobel-laureate-level research to pursue out-performance. This involves overweighting according to proven “factors,” such as value, smaller size, and higher profitability.
  4. Thoughtfully use reduced-volatility equities for intermediate-term goals.
  5. Consider working with a thoughtful, educated advisor to address these concepts, and to make sure the proportion of equities in your portfolio is appropriate for you and your situation.

Concentration vs. diversification: Practical considerations

So how do you “get there from here,” if you are heavily concentrated in one or a few positions? How should you approach reducing those positions?

We suggest you work with a thoughtful advisor to consider the following practical dimensions:

  1. Behavioral biases – Be aware of behavioral biases which could be concentrating your portfolio for less-than-ideal reasons, such as: Familiarity bias, overconfidence, or emotional attachments to investments that represent a big personal “win” or an important inheritance.
  2. Overall net worth – A $1 million investment isn’t the same for everyone; it’s all relative. Consider how large the concentrated investment is relative to your overall net worth. Investing your first $1 million in a single stock is significantly different than investing an incremental $1 million in a single stock.
  3. Tax implications – Think through the potential tax bill that could be generated by selling current positions to diversify, plus the ongoing costs to rebalance a diversified portfolio. At the same time, it’s important to not let tax considerations overwhelm your primary investment focus: If you’ve decided that increased diversification would benefit your portfolio, don’t let taxes and other costs get in the way. There are multiple ways to manage potential tax implications, including:
    • Staggering sales – Exiting positions piece-by-piece over multiple tax years to minimize tax consequences.
    • Use of stock options – When done appropriately, options can be used to protect your concentrated positions from a significant drop in value, without triggering the large tax liability that would come with selling the position.
    • Tax loss harvesting – Selling a security at a loss, if possible, to help offset taxes on gains.

If you’re unsure how to approach the concentrated equity exposure in your portfolio, we may be able to help. Please contact us to request a complimentary review of your financial affairs or to start a conversation (some restrictions apply). Or click here to see our Managing Partner, Tom Gerson, speak about Blair Hall Advisors' history, approach, and values.