Lose Your Concentration: How To Protect Yourself from Single Stock Risk

If a single stock makes up 10% or more of your investment portfolio, or if a major decline in the value of one stock will significantly impact your financial plan, you have a concentrated stock position.

A concentration in one stock in itself is not a bad thing – in fact, you may owe a significant portion of your wealth thanks to it! But as Warren Buffet once said, “Don’t try to get rich twice.” Now that your wealth has been built, diversifying out of hefty single stock positions can reduce risk and help grow your wealth for many years.

An Unnecessary Risk

The concern with having a concentrated position is that it poses a significant risk to your financial wellbeing in the long run. Why? Because a single stock carries significantly higher risk of a serious loss compared to a diversified portfolio.

A 2017 J.P. Morgan study showed that roughly 40% of all stocks in the Russell 3000 Index (which tracks most publicly traded companies in the U.S.) suffered serious and permanent declines of more than 70% from their peak value between 1980 and 2014. During the same period, over 320 companies lost their spot in the S&P 500 altogether for business distress reasons.¹

There are unique risks that come with owning a single company.² While the collapses of companies like Enron or Lehman brothers are dramatic, huge losses in a single stock can actually be fairly common over long time periods.

The good news is that taking that risk is unnecessary for the modern investor. Mutual funds and ETFs make it easy and affordable to diversify your stock holdings across thousands of securities, virtually eliminating company risk from your portfolio.

Diversification can sidestep the risk of a large loss from a single stock by investing in the entire index, without sacrificing the solid returns stocks can provide. Despite the minefield of single stock risk, a $10,000 investment in the Russell 3000 index in 1980 would be $980,800 by the end of 2020.³ An astounding 11.84% average annual return over the period.⁴ 

What would you do if you were offered $980,800, or a 40% chance at nothing or 60% chance at $2,000,000? Loss aversion is a human tendency that says the pain of losing is psychologically twice as powerful as the pleasure of gaining⁴. In other words, it’s better not to lose $980,800, than to find $2,000,000⁵. Yet when it comes to stocks, people have a hard time making the decision to diversify due to a few barriers.

Overcoming the Emotions

I know what you might be thinking – but MY stock is a WINNER. The most common response we see from individuals against diversifying out of a concentrated position is the fear of regret if the stock outperforms the broader market.

Why sell something that has done so well in the past and feels like it will continue to outperform? It may feel counterintuitive to sell “a winner”, but just because a stock has performed well in the past does not mean it will necessarily continue to do so in the future.

When you consider how single stock concentration comes about, it’s hard to be objective. The most common sources of stock concentration are:

• Compensation through your job, such as stock options or restricted stock
• Gifts from an inheritance
• Stocks you bought that performed way better than anything else in your portfolio

In each circumstance, biases come into play. It’s human nature to think our company will do better than others, we feel emotional ties to stock gifted by family, and it’s natural to believe that “winners” will continue to do well. We work regularly with clients to navigate these emotions and create a plan that can reduce their single stock exposure over time.

Getting Comfortable with Tax

The number one mistake I see with clients is where tax leads their decision making process. Nobody likes to pay tax, but it is an unavoidable contract we make living in a society. You will need to pay taxes on the gains eventually (unless your stock loses all the gains, you give it away to charity, or you pass away and your stocks get a step-up in basis).

Think of it this way: the fact that you owe tax means that you won, you made a profit from your investments. You are taking some profits off the table, and either investing the winnings in a diversified portfolio for a greater chance at sustainable long-term wealth, or you’re using it to fund a large purchase or an experience you will cherish. 

How to Lose Your Concentration

If you have a concentrated stock position, you know the emotions that come into play. The best way to overcome them is to create a selling plan. Your selling plan is a methodical approach to diversifying over time. The exact amount and time interval will depend on your financial situation, but one example of an appropriate strategy could be selling 15% of the concentrated stock position each quarter. Another example might be to sell 60% of your concentrated position in year 1, and spread out the rest over the next 4 years.

Creating a selling plan has many benefits. You take emotions out of play by selling on a set schedule. The tax bill gets spread out over time, which could mean paying less in taxes by maintaining the capital gains tax at the 15% rate. And since you’re not selling everything at once, it can be an emotional compromise if you’re concerned about selling too early. You can start reducing the exposure to a single stock while still participating in the stock’s growth if it goes up in the near future.

Once you sell the shares, reinvest the proceeds into a diversified portfolio. Often, clients count on that stock position for something special. It’s the down payment on a home, freedom to take a break from work, or the chance to volunteer full-time for a non-profit.

So create that goal in BrightPlan to give yourself a timeline, and we’ll provide an appropriate investment strategy for your goal. 

See Your Stock Concentration

Do you have single stock risk? BrightPlan shows you exactly how much of your investments are held in individual stock. Sign in to BrightPlan and link your investment accounts today to get your checkup.

Disclosure: past performance is not indicative of future results. Investing in securities involves significant risks, including the risk of loss of the entire investment.

Note: This material has been prepared for informational purposes only and should not be used as investment, tax, legal or accounting advice.  All investing involves risk. Past performance is no guarantee of future results.  Diversification does not ensure a profit or guarantee against a loss.  You should consult your own investment, tax, legal and accounting advisors.

Sources:
1. Concentration, Understanding the Rewards and Risks, J.P. Morgan Private Bank. 2017

2. Nobel Prize Winner Harry Markowitz pioneered the work in portfolio diversification, showing that while market risk cannot be diversified away, company risk can. He recommended investing in at least 30 companies in different industries to insulate your holdings from company risk. The three major stock mutual funds in a BrightPlan portfolio do more – they collectively own more than 10,000 stocks in companies from 46 different countries.

3. Past performance is not indicative of future results. Investing in securities involves significant risks, including the risk of loss of the entire investment.
4. Annualized Russell 3000 return with dividends reinvested, 1980-2020. From YCharts
5. Prospect Theory; https://en.wikipedia.org/wiki/Prospect_theory