Imagine this: You’re a relatively healthy person. You eat right and exercise regularly -- perhaps you even run a few miles every other day to stay in shape. From the outside, you’re the picture of good health.
But at recent annual check-up, your family physician notices something on your chart that is alarming. It appears that all of the running you’ve been doing over the years, while seemingly beneficial to your health, has been quietly deteriorating your knees. To make matters worse, based on his assessment, you would need to stop running immediately and take up other forms of exercise if you wish to avoid any long-term damage.
You may be thinking, “It’s running! I’ve done it for years, I see the positive impact it’s had on my life. How could something that is so outwardly beneficial, have the potential for such long-term damage?”
Now, I’m no physician, but I’ve had countless conversations that follow this same line of reasoning. Clients with portfolios that consistently produce solid returns are, many times, unaware of a huge underlying issue -- that unaddressed, could potentially sabotage their best laid financial plans.
What is that inherent danger, you ask? A concentrated stock position.
Due to a number of different circumstances, many investors have overly weighted their portfolios with holdings in one specific stock and left themselves vulnerable to potential financial ruin should that stock fail to perform over the long run.
There’s a fine line between investing and gambling, and focusing too heavily on the strength of one stock, puts you squarely in the category of the latter. Clearly this is not to discount the fact that plenty of people have become extraordinarily wealthy as a result of making a “great stock pick”. However, there are millions of others that jeopardized their entire financial future by utilizing that same approach. Just ask those who bet their retirement nest egg on Worldcom and Enron stock.
For context, we should first define what constitutes a concentrated stock position. Since I tend to view things from a risk perspective, I gauge a portfolio’s level of exposure as: 50% or more -- extreme danger zone, 40% -- significant danger, and 10% -- "Is this smart? Is this worth it?"
Drawing from the old adage of “putting all of your eggs in one basket”, it would be easy to concede that upwards of 40% concentration is an appropriate time to question your exposure risk. But what if only 10% of your portfolio is in one particular stock -- that doesn’t hardly seem like “all of your eggs”, right?
Or does it?
While your theoretical basket may not be completely full, bear in mind that you are on a very slippery slope that could easily take your portfolio from 10% to over 50% in the blink of an eye.
Consider these examples. You may have:
Each of these instances provide the opportunity to disproportionately increase your risk due to the amount of your portfolio concentrated in one stock.
“But, Andrew, you don’t understand...my shares of XYZ have performed really well -- they’ve even out performed the overall market by...”
That’s great, but the truth is, you’ve been very lucky! In order to continue that streak, that stock would have to continue to perform well over time and that is not a given. With economic uncertainty, governmental regulations, and a host of other potential issues, you end up with a portfolio that has extreme volatility. In a worst case scenario, your stock could bottom out, and leave you with massive losses.
From a planning perspective, it is difficult to create a strategy or even income projections around a portfolio with concentrated stock positions, because the luck component in the equation now far outweighs the skill level of the advisor.
Still not convinced? Consider the recent examples of overconfidence exhibited by employees of Enron, WorldCom, and Lehman Brothers that lost most, if not all of their retirement savings due to investing too heavily in company stock.
Although these individual trials have long since ended, similar stories of employees risking excessive amounts of their retirement income remain in the news. That said, now is as good a time as any, to review your investment portfolio and determine if you’re holding too much of your retirement nest egg in one stock.
As with most things, emotion plays a large part in our decisions -- and our behavior related to concentrated stock positions is no exception.
Realizing significant growth in your investment portfolio is a euphoric feeling -- and justifiably so. Unfortunately, these emotions can often lead to investor overconfidence -- which is NEVER a good thing.
Don’t let your emotions override discipline.
Start by getting your emotions in check. Although you may feel loyalty to a particular company or stock because of familiarity, family obligations, or some other deeply held belief, the fact remains that basing portfolio decisions on your heart over your head, is generally a recipe for disaster.
Next, determine your total exposure to concentrated stock positions. Make sure your totals include single stocks, stock options, and any additional exposure to a particular stock through mutual funds.
If any particular holding exceeds 10% of the value of your total portfolio, that may signal a need to diversify your assets.
And finally, seek the counsel of a Certified Financial Planner™. There’s no question that you are fully capable of planning for your financial future alone. But just because you can do something, doesn’t mean you should. Engaging with a CFP® allows you the chance to receive an objective analysis of your entire financial profile: including risk tolerance, tax consequences, and future financial obligations -- which becomes imperative the closer you are to retirement.