Diversifying Concentrated Stock Positions: Navigating the Path Less Traveled

Generating wealth and retaining wealth can be two conflicting skillsets, especially when a major source of that wealth is a concentrated stock position. The former requires bold risk-taking, optimism, and allowing eggs to pile up in one basket. The latter requires planning, humility, being proactive, and a certain degree of paranoia. Navigating this shift in mindset and beginning the process of diversifying out of your high-flying stock can be incredibly challenging. It has just as much to do with human psychology as it does finance, and rare is the individual who is able to flip the switch from accumulation to diversification effectively.

To be certain, owning a single stock that has ballooned to make up a significant portion of your investment portfolio is the epitome of a “good problem to have.” Nonetheless, the decision to retain, reduce, or eliminate the risk of a concentrated position can impact your family for generations.

Consider your financial journey as a road trip, and your concentrated position is the equivalent of a winding, gravel short-cut coming into view. Is it an amazing opportunity that makes the rest of your trip a breeze and allows for a more pleasant and scenic future? Or is it overly dangerous, complicating what otherwise would have been a smooth journey, leaving you with a stressed-out spouse and car-sick kids in the back? A concentrated position has the potential to be both. This short-cut is full of unknowns and factors out of your control, including the individual company’s control, which adds to the risk of getting too far down this shortcut path unprepared. So, how do you know if it’s right for you to be on this road or time to head back to the interstate, or at least something a little less treacherous?

Are you Already on A Detour Route?

At Coldstream, we define “a significant portion of your investment portfolio,” as greater than 10%. If you own shares of your employer’s stock, have additional vests on the way, and still earn a salary and annual stock refresh, you may have more exposure than indicated by your monthly brokerage statement. Having the majority of your financial future dependent upon one company can make for an impressive looking, yet fragile balance sheet and financial plan. Although your vested and held shares may not make up more than 10% of your investment portfolio currently, it may be prudent to consider future vests and salary in the equation of how much to wager on one company.

What’s The Risk?

Warren Buffet once famously told a class of MBA students at the University of Maryland:

“The most important quality to do well [in finance] is temperament which would permit the control of fear and greed which have ruined many. Anyone who has become rich twice is dumb. Why would you risk what you need and have for what you don’t need? If you are already rich, there is no upside to taking on a lot more risk, but there is disgrace on the downside.”

When it comes to investing in a single company, there is substantial risk of loss, and it’s more common than many realize:

• 64% of individual U.S. stocks have underperformed the stock market’s average. Put another way, you have a 36% chance of coming out ahead when comparing a single company to the average. Why do people take this chance, given the odds? Well, it’s certainly possible to be very right through outperformance. The problem is, a lot of investors who have experienced this keep rolling the dice again and again, hoping they keep hitting the 36% every year.
• The risk of being very wrong is real, even for large companies. Twenty-one S&P 500 companies lost at least 50% in 2022, and the five biggest losers on a percentage basis were all down more than 65%.
• Just 4% of stocks from 1926-2016 created all the excess return for stocks above U.S. Treasury Bills. Put another way, the broader “market” benefits from a handful of companies performing extraordinarily well for short periods of time. The problem is, nobody knows with any certainty which companies it will be, when the outperformance will start, and for exactly how long. Typically, those that experience a wildly positive ride also experience long stretches of lagging performance or even disaster on one or both sides of that positive stretch.

When making a bet that’s expected to lose more than it wins, there must be an additional upside. The most extreme example is buying a lottery ticket. Winning isn’t likely, but the upside is huge. The question is, do you want to be the person that wins the lottery and spends it all buying more tickets?

Why Is Selling So Hard?

Inertia: Tendency to maintain the status quo. In the lottery example you have to buy more tickets; continuing to hold stocks is the equivalent. You are continually buying more tickets as you hold, and only by selling do you prevent that action from continuing. If selling were automated (possible in some instances with a 10b5-1 plan) or on the radar of an investment professional, many would have an easier time reducing concentrated positions and diversifying their holdings.

FOMO: Fear of missing out on potential future gains. Nobody wants to be the person at work who regrets selling “too early” every time they see their colleagues’ new cars in the parking lot. However, they ignore other equally likely scenarios of those same colleagues watching their net worth evaporate quickly and then are stuck with a car payment they can no longer afford, or struggling to save enough for their kids’ college tuition coming up.

Recency Bias: The tendency to give greater weight to recent events can cause people to have unrealistic expectations about the future performance of their concentrated stock. The concentrated position is likely concentrated for a reason: it’s done well! If recent positive performance is the only thing you’ve experienced, you may associate the company (often subconsciously) with nothing but positive performance going forward.

Other Fears: Some are afraid of selling the wrong stock lots or creating extra taxation for themselves (often a misconception), and thus stand-pat with their concentrated position.

Hazard #1 – Industry Headwinds

A bad storm can derail even the best of vehicles on this short-cut.

As the old saying goes, “a rising tide lifts all boats.” Well, the lesser discussed inverse is true as well. 2020 and 2021: rising tide. 2022: the tide went out, taking many quality boats with it.

Since Jan. 1, 2022: Meta, down 70%. Tesla has shed 65%. Netflix, a 53% haircut. Peloton, -77%. Twitter, Netflix, Amazon, Microsoft are all down more than 30%, and the list goes on.

Are all these companies fundamentally different than who they were at the end of 2021? No. But, industry risk and interest rate risk have wreaked havoc upon these previously high-flying tech darlings. Risks outside the control of a single company are often vastly underestimated by employees. Having enough humility to attribute many of the gains and potential declines to tides, rather than boats, is key to navigating a concentrated position well.

Hazard #2 – Emotions and Bias

It can be mentally and emotionally challenging to diversify away from one stock, as questions of “what if it keeps going up?!” and dollar signs dance in one’s head.

Commonly, the concentrated position is also that of a current employer, so there’s added interest in having “skin in the game,” and often the investor/employee will be bullish on the future of the company. They see what great things are happening, and the direction the company is headed. Plus, peer pressure doesn’t stop after middle school: Can you imagine going to happy hour with colleagues every day who got super rich on the company stock while you sold at a lower price? It’s not as fun to talk about the performance of an index fund, and these colleagues won’t want to hear about your 10% return in a year where the company stock was down 30%. Keep in mind, diversifying doesn’t mean you need to sell all your company stock, and perhaps you have more vests on the way.

It’s also worth remembering, stock prices don’t just change based upon good or bad company performance; they can change based upon financial performance being better or worse relative to analyst forecasts. Expectations of future cash flows are factored into current prices. A company could be amazingly profitable over the next five years and still see a negative return if they aren’t quite as profitable as analysts had anticipated.

Summary

Some end up on the concentrated position road unintentionally and make it back to the interstate right away, thankful for a bit of a shortcut by happy accident. Others notice themselves heading down the path and inertia takes hold, aided by temptation, recency-bias and grand visions of more, more, more. Most people lie somewhere in between, just trying to navigate the best path for themselves and their family: not too conservative, but not too risky. The definitions of conservative and risky are different for everyone, and a trusted advisor can help define those parameters. Another question to answer is, “how much is enough?.” Having a reference point of “enough” can be an incredible north star to help guide you on this path successfully.

No matter which route you take, the concentrated position trip will end in one of four ways:

1. Hold and Die – you pass away before selling your shares, passing them along via your estate plan. This is a way to avoid large capital gains in a taxable account, as they receive a step-up in basis upon your death.
2. Sell – Realize the proceeds, either to reinvest or use otherwise.
3. Donate – Allows avoidance of large capital gains.
4. Watch Them Drop – Decline in stock price brings you below the 10% concentrated position threshold.

Like most investing decisions, there is a risk vs. reward trade-off. Recognizing when the risk outweighs the reward is key to knowing the right path ahead and what the ideal ending to your trip looks like for you and your family – not your neighbor, not your colleague, and not your sibling. Your Risk vs. Reward equation is certain to change over time, so routinely recalibrating your ideal amount of risk relative to current exposure is key to a great trip.

Continue your diversifying journey with our Part 2, Diversifying Concentrated Stock Positions: Creating a Roadmap.