Single Stocks And Concentration Risk
Last week we were asked to address this topic for an article – we get our best ideas from clients. As the investment adage goes: you get rich through concentration, you stay rich through diversification. It holds a lot of truth. Knowing what to do and when is a question of matching risk with reward. Consider these concepts and questions if you currently hold a significant piece of your wealth in a single entity or are thinking of doing so.
Two tickets, please
Know the ups and downs and get ready to put you and your spouse on a wild ride. Indexes, like the S&P 500, don’t double in value, double again and drop 75% only to hit a new high 12 months later. Single stocks, especially tech stocks, do this regularly. That’s what makes a concentrated position so powerful in wealth creation, they can win, and win big.
So how much is too much?
If you tend to live below your means, you probably have sufficient room to swing for the fences on a handful of single stock bets. Investors with extra capital and high savings rates simply have enough extra money to take risks. If a big sell-off would put you in a pinch, a concentrated holding is not the answer.
A few questions to ask yourself
Most often, people tell us that money represents freedom of choice. Ask yourself, would a 50% drawdown in Stock “A” have a material effect on your quality of life? What would be the impact on your plans, tuition payments, mortgage payments or financing your child’s wedding? Hoping for the best isn’t a strategy. Beyond the obvious pain of loss of capital, how would a significant drawdown in your concentrated position disrupt your lifestyle? Have you built a lifestyle that is now larger and costs more than your current risk level can handle? We can help you answer these questions. Be aware of building castles on top of sand.
Slow and steady
Wealthy individuals became wealthy mostly due to a combination of two factors: saving more and spending less – see Make More or Spend Less?. However, there are third and fourth ways which are not often discussed but happen all the time: marriage and inheritance. Those of you who grew your wealth through slow and steady savings rates probably don’t have a problem with investment patience. For those of you who quickly gained wealth through big stock option payouts, large inheritances, or through marriage, money can seem plentiful and endless. Patience, or any lack thereof, is a crucial investment value.
The Apple effect
Investment FOMO (fear of missing out) is real! You probably know more than a dozen people who talk about buying Apple, Amazon, Facebook or even Bitcoin before it was worth what it is today. Don’t listen to it. They won’t ever tell you about the stocks that failed them and your imagination is likely to give those storytellers far more credit than they deserve.
The executive’s dilemma
Like it or not, economic, political or industry events can wipe out shareholder value regardless of a company’s ability to hit or exceed targets. Even executive officers who have direct control and oversight of their businesses have very limited control of their company’s stock price. If nothing more than an exercise in humility, take an inventory of your expenses and double check that a significant drawdown in your company’s stock, likely your largest holding, won’t wreck your lifestyle.
It all comes down to downside risk – how much can and should you withstand? Even if concentration has made you wealthy, it may be time to let diversification do its job and keep you wealthy. We can help you understand your risk level and consider your options.
Max Osbon – firstname.lastname@example.org