The Hidden Cost of Holding a Concentrated Position Why diversification can help to protect wealth By Baird’s Private Wealth Management Research Executive Summary Family wealth created by holding a single stock that appreciates substantially in value over time is fairly common. For example, senior company executives receive stock or stock options as part of their compensation, investors benefit from superior appreciation of one stock relative to the rest of their portfolio or family members inherit a large position in a single stock. Regardless of how the concentrated position is acquired, it results in a disproportionate allocation of wealth, which exposes the family to undue risk that should be understood and managed. Whether investors understand the risks of holding a concentrated position or not, there is a tendency to hold onto these positions. Corporate executives may face insider selling constraints or concerns about how a sale would affect the market price of their company’s stock. Other investors simply have an emotional attachment to the stock. Many investors are concerned about the tax implications of selling. Despite these seemingly valid reasons, there is a critical point for most investors and families where the desire for wealth, income and lifestyle preservation outweighs the need for further wealth creation. This is especially true when investors approach retirement or life events during which they will more heavily rely on their accumulated wealth. The goals of this paper are to educate investors about the hidden risks associated with holding significant wealth in concentrated positions and to suggest strategies to help mitigate and manage those risks. The Risk/Reward Implications of The results of this study showed Defining a Concentrated a Concentrated Position that over one-third of the individual Position Investors who have benefited from stocks underperformed our 60/40 A concentrated position occurs holding a concentrated position often diversified portfolio, and that all of when an investor owns shares believe that past performance will the individual stocks showed much of a stock (or other security continue indefinitely, and may find higher volatility. The average stock’s type) that represent a large it difficult to imagine a downside. volatility was more than three times percentage of his or her overall While it’s tempting to believe a that of the diversified portfolio. There portfolio. The investor’s wealth stock’s market outperformance is no perfect way to know which becomes concentrated in the will continue, studies show that stocks will be the winners over the single position. Depending on investments in a diversified portfolio long term, and the cost for being the volatility of the stock and can produce greater long-term wealth wrong can be high. For example, the the size of the client’s portfolio, a than investments in a concentrated return of 55 stocks failed to keep pace position is often considered to be position, with significantly less risk. with inflation over the period, and concentrated when it represents 37 of the 309 stocks had a negative 10% or more of one’s portfolio. In order to better understand the return for the decade. risk/reward trade-off of holding a concentrated stock position, Baird A good example is General Electric. constructed a hypothetical diversified The chart below compares the portfolio consisting of 60% equities performance of General Electric’s and 40% fixed income and compared stock to the diversified portfolio over it with the 309 individual stocks that this 10-year period. GE experienced remained consistently in the S&P a 1.9% annual rate with 28.9% 500 Index for the 10-year period of volatility, while the diversified September 30, 2006, to September portfolio generated a positive annual Concentrated Equity Position: 30, 2016. return of 5.8% with much less “What If” Analysis Single Stock Position vs Diversified Portfolio $200,000 Growth of $100,000 Investment, Past Ten Years GE $180,000 $175,467 Diversified Portfolio $160,000 Diversified Portfolio $140,000 GE Diversified Portfolio $120,000 $120,154 10-Year Higher $100,000 1.9% 5.8% Annualized Return Return $80,000 10-Year Less 28.9% 9.2% $60,000 Annual Volatility Volatility $40,000 GE Diversified Portfolio (total=100%) $20,000 Equity 0 Large-Cap Value 14.0% Large-Cap Growth 12.0% Sep-06 Jul-07 May-08 Mar-09 Jan-10 Nov-10 Sep-11 Jul-12 May-13 Mar-14 Jan-15 Nov-15 Sep-16 Mid-Cap 8.0% Source: FactSet Research Systems; Baird analysis. Small-Cap 4.0% The following indices are used to represent the diversified portfolio: Large-Cap Growth: Russell 1000® Growth International 14.0% Index; Large-Cap Value: Russell 1000® Value Index; Mid-Cap: Russell Midcap® Index; Small-Cap: Russell 2000® Index; International: MSCI EAFE; Taxable Fixed Income: Barclays Capital Intermediate US Govt/Credit Taxable Fixed Income 40.0% Index; Satellite: MSCI Emerging Markets Index, Barclays Capital US Corporate High Yield Bond Index, Satellite 8.0% DJ UBS Commodity Index, DJ US Select REIT Index. Russell® is a trademark of the Frank Russell Company. Indices are unmanaged and a direct investment can not be made into an index. The analysis was performed by Baird’s Private Wealth Management Research department. - 2 - volatility (9.2%). Importantly, this is As Table B shows, Investment II, the less not an isolated case. Baird has calculated volatile of the investments, generates similar results for dozens of companies, a much higher compounded growth including US Bank, Cisco Systems, rate of 9.9%, compared with 2.5% for Exxon Mobil and FedEx. In many of the Investment I. As a result, a $1,000,000 “what-if ” analyses we conducted, the investment in Investment II grows to diversified portfolio outperformed the $1,207,500 in two years. That’s over single stock position, and in all $150,000 more than Investment I cases the diversified portfolio had simply because of the investment’s lower lower volatility. volatility. In summary, the more an investment’s return fluctuates year by So why does a diversified portfolio often year (i.e., the higher the volatility), the outperform a single stock position? greater the drag on the compounded The answer lies in the lower volatility. growth rate and the lower the future As our study and others like it have wealth. Thus, controlling volatility and indicated, greater volatility in a portfolio risk through proper diversification does reduces compounded growth rates and matter in portfolio management. future wealth. The example in the tables below illustrates this point through two While investors may be tempted to hypothetical investments that generate hold a concentrated stock position in the same average annual return of 10%, the hope of greater profit, they may fail but with varying levels of volatility. to understand that they are not being In Table A, Investment I averages a compensated for taking this risk. In 10% return but is the more volatile theory, stocks are riskier investments that investment, increasing 50% one year and should provide higher returns than less decreasing 30% the next. Investment II risky investments like Treasury securities. also averages a 10% return; however, it is However, the risk/reward premium less volatile, up 15% and 5% in the two turns against the investor when too few years, respectively. stocks are owned, and especially when the investor holds a single or large, TABLE A: dominant position. Returns become too Averages Can Be Misleading reliant on the fortunes of one company Investment Year 1 Year 2 Average Volatility (exposing the investor to significant company-specific fundamental risks) I 50% -30% 10% 40% and to a single industry (exposing the investor to sector-specific risks). As a 15% 5% 10% 5% II result, it is clear that investors should choose to diversify a concentrated stock TABLE B: position whenever possible. Why Volatility Matters Investment Original Investment Year 1 Year 2 Compounded Growth Rate I $1,000,000 $1,500,000 $1,050,000 2.50% II $1,000,000 $1,150,000 $1,207,500 9.90% - 3 - Why Are Some Investors The True Tax Consequences Today’s Capital Gains Reluctant to Sell? of Selling Rate Environment Despite this compelling argument, One of the biggest objections to It’s widely agreed that tax we have found many investors selling a large appreciated stock considerations, while important, are reluctant to sell concentrated position is the need to pay income tax should not be the only reason for positions. A few of the most on the gain. With a cost basis that can making an investment decision. common reasons investors don’t sell be as low as zero, the tax implications The investment merits of owning are summarized in Table C below. in dollar terms of a sale can seem the stock should supersede the Although many of these reasons are significant. However, we have already tax considerations of selling. valid in the eyes of the investor, the shown how a diversified portfolio can Nevertheless, investors who logic supporting diversification is build greater wealth with less risk than currently own a large stock compelling. We will now turn to a single-stock position. In the study position should consider the some ways an investor can successfully referenced, even in a decade when the impact of capital gains tax rates diversify and minimize the risk of a S&P 500 was up 5.3%, 25 stocks when contemplating a sale. concentrated position. were down 20% or more in value at While higher than they were in the end of 10 years – roughly the early 2000s, long-term capital equivalent to a payment of 15% gains rates are still at or near historical lows for most taxpayers.