Don’t Concentrate too Hard: Three Reasons to Develop a Strategy to Manage Concentrated Stock
When it comes to portfolio risk management, many investors are familiar with the concept of diversification and the analogy of not putting all your eggs in one basket. Spreading out your investments across uncorrelated asset types or sectors can be an effective strategy to reduce your exposure to market volatility over time.
But sometimes a concentrated stock position – a single investment that represents an outsized portion of one’s overall portfolio – can develop because of events beyond our control: acquired as part of a compensation package or through an inheritance, perhaps.
For some investors, the right concentrated position can end up being beneficial. As Warren Buffett quipped, “Diversification may preserve wealth, but concentration builds wealth.” This can be true, if you’ve chosen a particular concentration wisely, but as these investments grow there are common complications and/or risks that crop up -- particularly if you don’t happen to be Mr. Buffett:
Sharp and dramatic declines: Stocks are volatile and subject to their own idiosyncratic risk, which is risk unique to that company. It may be that its earnings are weak or that it suffers a period of slowing demand, sending the position’s value, and that of an overall portfolio’s, precipitously lower.
Extended stagnation: Sometimes idiosyncratic risk doesn’t manifest in sudden and intense volatility, but rather in periods during which a stock’s performance lags that of the broader market, leaving investors exposed to inflationary risks and opportunity cost.
Tax burden: Concentrated stock positions often sit upon a cushion of large unrealized gains that can act as a disincentive to diversify.
It is important to have a strategy for managing periods when a concentrated position suddenly goes from right to wrong, or when preserving wealth and/or generating income takes priority over growth. Depending on an investor’s objectives, there are a variety of methods that can address the risks described above, ranging from the simplistic to the more complex:
Risk reduction: It is possible, using certain strategies and tools, to place guardrails around a concentrated position’s volatility, controlling the degree of loss or anticipated outcome and ensuring that a large decline in price doesn’t torpedo your entire portfolio’s value.
Income production: Other strategies can generate income from a concentrated stock position to create supplemental return, which can be particularly effective when a position’s growth has stagnated.
Tax reduction: If the goal is to reduce exposure over time for diversification or liquidity considerations, strategies can be deployed that will maintain market participation while incorporating systematic tax-loss-harvesting to offset the gains realized by the periodic sales of the concentrated position.
If you carry a concentration in your portfolio and have not yet explored such strategies, we encourage you to discuss them with your Advisor to see if they may be right for you, lest your basket of eggs become one very expensive omelet.