Concentration: The Abundance of a Constituent Divided by the Total Volume of a Mixture

Don Deyo, EVP, Chief Investment Officer

In the world of investments, concentration represents the placement of capital in a single security, sector, industry, or asset class. Concentration typically increases the risk of loss in a portfolio because concentrated investments can move together in an unfavorable direction. On the other hand, diversification of assets can insulate a portfolio from volatility and potential downturn by limiting the breadth or depth of losses across the investment mix.

It is not unusual in the world of trust and estate planning to encounter client portfolios with an ignored or overlooked ‘concentrated’ position. While investors can have overweighted positions in equities, bonds, real estate or cash, investments in individual stocks represent the most common form of concentration. Most people would define this type of concentration as a portfolio which is comprised of a single asset comprising more than 10% of total investments.

At a point in life, individuals begin to plan for aging and to confront how to manage their wealth for themselves, their families, and their philanthropy. As each of us nears this point and leaves a consistent paycheck behind, we want to be sure our investments provide adequately for ourselves and our family’s current and future needs, as well as for our beneficiaries. It becomes critical that we inventory our wealth and wealth composition and make decisions designed to help us navigate life’s changes, usually by reducing volatility and risk in order to increase the likelihood our assets will help us achieve our stated goals.

The impact of acquiring and holding a single investment over many years is magnified when we move from the asset accumulation stage to the point of relying on the assets for income or other needs. This could be prompted by sale of a business, retirement planning, estate planning or inheritance. Confronting concentrated positions is part of a sound strategic plan to minimize risk, preserve capital and improve investment returns. As the accumulated wealth planning cycle begins, it is extremely critical to get trusted professional guidance from legal and financial professionals who can advise on diversification and other actions specific to individual needs and circumstances. It is easy to lose objectivity with our own portfolios, and the emotion surrounding restructure can be daunting. A host of variables should be considered along the way.

People find themselves with single asset concentrations in one of four primary scenarios:

• Employment (Employer Stock as part of compensation),
• Inheritance,
• Substantial price appreciation,
• Sale of a business.

Negative consequences of concentrated positions

Regardless of how it happens, concentrated positions can have two major negative consequences: lack of diversification and increased portfolio risk. Numerous studies indicate that a well-diversified portfolio results in increased long-term wealth creation and a commensurate reduction in overall risk than a portfolio with a concentrated position. After all, there is no way to forecast which stocks will perform well over any plottable long-term cycle and the cost of getting it wrong can be immense.

Investors cannot rely on historic price performance repeating itself. When returns are reliant on a single asset or industry the risk quotient is high, creating greater volatility than a rational investor would otherwise tolerate. And with increased volatility comes a drag on compound growth rate and lower wealth into the future. Everyone who has reaped benefit from holding a large single position likes to believe past performance will deliver similar success unchecked into the future or that sustained downturn will be visible ahead of time and there will be warning so that adjustment can be made ahead of any turbulence.

Shareholders of the following large, well-capitalized companies likely had similar views: Enron, Blockbuster, Lehman Brothers, Wachovia, Pan Am, Kodak, Compaq and even General Electric (the last founding member of the original 30 Dow Jones stocks). Many investors accumulated sizable positions over the years that suffered a fundamental meltdown in value. They faced the plight of a delayed retirement or a shattered wealth portfolio that could not feasibly be restored in their lifetime. For these reasons, concentrations can be dangerous to ignore.

The reasons for portfolio diversification

If there is any question remaining as to why concentrations are a potential ticking time bomb, let us outline the reasons for portfolio diversification.

Improves potential returns and stabilizes results. By investing in multiple asset classes and securities, investors can help reduce portfolio risk, since no individual asset or asset class will have an outsized impact if there is significant financial market upheaval.

It is worth citing a study by Robert Baird* which compared a 60/40 Stock to Bond portfolio to 309 individual stocks consistently in the Standard & Poor 500 Index over a ten-year period (2006- 2016). Over this period, one-third of the individual stocks underperformed the diversified portfolio and the individual stocks displayed higher volatility. Fifty-five stocks did not keep pace with inflation and thirty-seven stocks had negative returns over the period.

There is no method to identify with certainty which stocks will be outperformers, and which will be laggards over any long-term measuring period. Only history will deliver those results. But the cost of being wrong can be significant and devastating. Investing is not gambling, and investors should consider all potential outcomes before making sizable wagers. Diversification may place a ceiling on possible lofty results, but it can also raise the floor on significant losses. That is why the risk of outsized bets increases volatility of the portfolio. When an asset has inherently greater volatility it can have significant impact on the portfolio’s compound growth rate and, therefore, lower future wealth returns. Controlling volatility and risk are key components to successful portfolio management.

Why don’t investors reduce concentrated holdings?

The reasons vary but the one heard most often is the opposition to paying taxes; however, long-term capital gains rates are near historic lows for most taxpayers. And tax considerations should be only one factor in making investment decisions. Other factors to consider are age, health, overall portfolio value, portfolio diversification, cash flow needs. Obviously, a longer-term horizon, a low risk tolerance and potential high volatility would accelerate reduction and provide more time to recoup cost and rebuild wealth. Some other objections are:

• The belief the stock is going to continue to rise
• Loyalty to an inherited position from a respected family member
• Missing an opportunity for a price comeback,
• A belief the stock is immune from significant downturn.

Each one of these arguments is often fallacious and the risk of being wrong is great. Most investors who have concentration risk have no plan of action, no tax strategy, no legacy plan in place. There is a knowledge gap—simply not knowing what one does not know, an emotional attachment or there is simple procrastination. People do not like to confront mortality.

Reducing a position

There are a number of strategies to help soften the blow of reducing a position over time. Even if single asset accumulation comes from employment and there is a sale restriction, the IRS provides for sales through a 10b5-1 plan which requires legal documentation and defined numbers of shares and defined times of sale. There are costs associated with the plan and there are restrictions which need to be reviewed with a financial advisor, but such plans remove guessing and the temptation to renege on selling from the equation.

The best solution remains to sell down the holding immediately or over a defined period of time, spreading the tax bite over several years, thereby reducing exposure to market volatility and increasing compound growth rate over time and rebuilding wealth. It addresses the embedded risk and takes emotion out of the equation. Investors may also hedge their positions using derivative programs. This is a more sophisticated strategy, requires incurring some cost and incorporates equity option programs with a financial advisor, but it can control risk by incorporating a “Call” and “Put” action on an existing position. There are also exchange-traded funds whereby concentrated positions can be exchanged for a diversified market basket of equities over time (usually seven years) without incurring immediate tax implications.

Gifting can be a valuable tool, either to family members (in lieu of cash) or to charitable organizations where a tax deduction may be enjoyed while embracing philanthropy. With significant wealth there is the use of charitable trusts, employing gifting with cash flow elements. It requires a legal instrument, and the gift of appreciated stock or other assets must be irrevocable and should be considered when the investor has charitable intention already. However, it can provide steady cash flow to the donor and, at trust termination, the remaining position can transfer to a named charitable entity.

To be fair, there are situations where selling down a large single position could be inadvisable. The most likely scenario would be an expectation of imminent bequest, where assets are going to be transferred in the near term and the heirs may enjoy a step-up in tax cost basis. This means that the tax basis would be moved to current value at the decedent’s date of death and the position could be sold with virtually no tax due. Each situation must be carefully analyzed and requires planning. In every scenario the goal is protecting wealth. The same asset that may have delivered extreme family wealth, at some point, may present itself as the family’s greatest financial risk.

One last set of statistics before closing. In the twenty-eight years from 1993 to 2021 the Standard and Poor 500 Index had:

• 216 companies remain in the index
• 232 companies were acquired, merged, or had market capitalization declines forcing them from the index
• 44 companies declared bankruptcy
• 4 companies were privatized
• 2 companies were placed under quasi-government supervision

These statistics underscore the risk of concentrating wealth in a single or only a few investments.

Investors build wealth over time. And with that accumulated wealth comes responsibility. It is important to realize that no situation is static--nothing lasts forever. Markets rise and markets fall. Investors must spend time not only accumulating wealth but also securing that wealth. By diversifying a portfolio, the investor can mitigate certain elements of risk, create a more sustainable growth pattern and provide for a long, comfortable lifestyle as well as providing for wealth transfer for generations. But it starts with planning and realizing wealth preservation is as important as wealth accumulation. Investors are benefitting themselves today and stemming future family pain by addressing concentration issues before they become onerous.    

*“The Hidden Cost of Holding a Concentrated Position,” c.2016 Robert W. Baird & Co. Incorporated

Arden Trust Company does not provide legal or tax advice. Please consult a legal or tax professional for advice specific to your circumstances.