October 10, 2019
The IRS Issues Final Regulations for New Hardship Distribution Rules
Earlier this year, we discussed several changes to hardship distribution rules resulting from...
September 19, 2019
Warren Buffett once said, “Diversification may preserve wealth, but concentration builds wealth.” While most Private Wealth Management firms place more emphasis on preservation of wealth when managing client assets, his comment isn’t untrue. Many individual investors and families build significant wealth through concentrated stock positions.
An equity position is generally considered concentrated when it makes up 10% or more of an investor’s investable assets. Concentration can result from a variety of events, the most common of which include:
Unfortunately, all concentrated positions present similar risks, no matter how they were acquired. At the same time, many investors with concentrated stock positions are reluctant to sell or diversify, despite the associated risks. This disconnect can make it difficult for investors to achieve their financial goals and can put their family nest egg at significant risk.
If you’ve held an outperforming stock for several years—maybe even decades—you may begin to believe that positive performance will continue indefinitely. However, as the position becomes a larger percentage of your overall portfolio, the ability to recover from a sudden drawdown becomes a more significant risk.
Consider the following hypothetical example:
An investor has accumulated a large position in XYZ Foods, and it now accounts for 50% of his overall investment portfolio. A different investor has a 5% allocation to a number of food companies through a diversified U.S. equity fund. The food sector suddenly takes a sharp downward turn, and all stocks in this sector lose 25% of their value in less than a week.
Without going through the math, it’s clear that the investor who owns XYZ Foods will be more impacted by this news than the investor in the diversified U.S. equity fund. A 25% hit to half your assets is much more painful than a 25% loss in 5% of your assets. And, the larger the loss, the greater the return needed just to break even.
Numerous publicly traded companies have seen their stock price decline permanently and, in some cases, go to zero. If you have a concentrated position in a stock that depreciates until it’s essentially worthless, your investable assets are suddenly a fraction of what they once were.
This risk compounds if you have a concentrated position in the stock of the company that employs you—a common practice since many employees receive stock as part of their compensation, can buy company stock at a discounted price, or simply feel more comfortable investing in a company they know. Unfortunately, if your income and investments are tied to the same company and that company does poorly, you’ve not only lost much of your retirement savings but potentially your livelihood as well.
Opportunity cost is the loss of potential gain from other investments when you concentrate your assets in a single position. Many investors fall victim to the sunk cost fallacy, meaning they commit to an asset because of the time and money they’ve invested in it. They fail to consider that many other investments could potentially make them more money.
It’s important to remember that all markets offer growth opportunities at various times. By committing to one U.S. stock, for example, you may be missing out on other profitable investment opportunities—possibly in emerging markets, real estate, or even fixed income.
While taxes shouldn’t be the only reason for making an investment decision, they’re an important consideration for many investors. Even if you’ve grown your initial investment exponentially, giving up a portion of your earnings to the IRS can be a tough pill to swallow. Since concentrated stock positions tend to be acquired at a low price (cost basis), they usually accumulate meaningful unrealized gains over time. This can trigger a large tax bill when the stock is eventually sold.
Still, in most situations, the long-term benefits of diversification (See Risks #1, #2 and #3) outweigh the short-term cost of paying taxes to reduce a concentrated position. While there are other means for reducing a concentrated position with potentially reduced tax implications, such as contributing the appreciated shares to a charitable organization or an exchange fund, reducing the concentrated position will typically result in a large tax bill.
Finally, one of the biggest risks of accumulating a concentrated position in a stock is the emotional attachment and irrational behavioral biases many investors develop as a result. In addition to the sunk cost fallacy, numerous behavioral pitfalls can play into holding a stock for too long, including overconfidence (thinking you know more than you do about a stock, possibly because you work for the company) and endowment bias (valuing an asset more just because you own it). On the other hand, many investors who inherit a large stock position from a family member have a difficult time selling it because it feels disloyal. Emotions and behavioral biases cloud our judgment and often lead to poor investment decisions.
At the end of the day, Buffett’s words still ring true. Yes, concentration can build significant wealth, but diversification typically preserves it. To meet your financial goals and leave a meaningful legacy for future generations, there must be a balance between growth and preservation. Overconcentration in a portfolio has the potential to threaten both objectives.
If you have a concentrated stock position and wish to diversify, talk to your wealth advisor about developing an appropriate investment strategy for you and your family.
Randy Joseph is a relationship manager for CIBC Private Wealth Management with more than 20 years of industry experience. He is responsible for business development and managing existing relationships for high net worth individuals and families.
* Required fields
Internal Custody:If your assets are custodied with Atlantic Trust, please select the internal custody version of Atlantic Trust Portfolio Online to view your portfolio information.
External Custody:If your assets are custodied with an external custodian, such as Schwab, Fidelity or The Bank of New York, you may access the external version of Atlantic Trust Portfolio Online.
Sponsored Funds Investors:If you are an investor in any of the Atlantic Trust Sponsored Funds, you may access the Atlantic Trust Investor Dashboard here.
Safari Browser Users:To access login links, you will need to deselect the "Block pop-up windows" option under your security preferences.
For further assistance, please contact your Atlantic Trust client service team.