Over the past few weeks, we’ve discussed some of the perils of single-stock ownership, as well as a number of behavioral biases that can result in concentrated positions. Unfortunately, the lure of outsized rewards can blind many investors to the risks involved. So what, then, is the impact of the failure to diversify on the individual investor? Luckily, there’s data on which outcome (the agony of a big loss or the ecstasy of a big gain) is more probable.
Which is More Likely, the Agony or the Ecstasy?
So, which is really the more likely event? Michael Cembalest of J.P. Morgan Asset Management provides us with evidence to help answer that very question. Cembalest examined a long history of individual stocks, and the risks and rewards of concentration. It’s important to note that while his analysis tackled individual stocks, some of the same issues apply to mutual fund investors who fail to diversify across asset classes or geographically.
Cembalest found that, over the long run, some companies did substantially outperform the broad market and maintain their value. However, the odds were stacked against the typical concentrated holder because there was a far greater risk of permanent impairment.
The following is a summary of his key findings:
- Using a universe of Russell 3000 companies since 1980, roughly 40% of all stocks have suffered a permanent decline of at least 70% from their peak value. For the technology, biotech and metals and mining sectors, the numbers were considerably higher.
- Broadening the analysis to include all stocks that were members of the Russell 3000 at any time from 1980 to 2014, a database of 13,000 large-cap, mid-cap and small-cap stocks was analyzed. Defining a catastrophic loss as a decline of 70% or more in the price of a stock from its peak, after which there was little recovery such that the eventual loss from that peak was 60% or more, 40% of all stocks suffered a permanent large decline from their peak value. Again, these are all stocks that suffered permanent, not temporary, declines, like those that may have occurred during the tech boom-bust or during the financial crisis. And though these loss rates tend to rise during recessions and market corrections, there’s a steady pace of distress even during economic expansions.
- Compared to the return of the Russell 3000 Index, the median stock in that index managed to underperform by 54%. And two-thirds of all stocks underperformed the Russell 3000 Index. For 40% of all stocks, their absolute returns were negative.
- Historically, there were some extreme winners. The right tail is about 7% of the universe, and includes companies that generated lifetime excess returns more than two standard deviations over the mean. However, after incorporating the issue of single-stock volatility, 75% of all concentrated stockholders would have benefited from some amount of diversification. Those are long odds to overcome, especially when the cost of being wrong can be so high. For example, you may already have sufficient wealth to meet your retirement goals, in which case there would have been little to no need to take this type risk.
In addition, Cembalest provided a partial list of exogenous factors that can put companies at risk and which are outside of management’s control:
- Commodity price risks that cannot be hedged away.
- Shifts in government policy, such as changes in service reimbursement rates, a slowdown in FDA approval patterns, bandwidth and other public domain privatizations that increase the scope of competition, changing subsidies for renewable energy, changes in carbon tax regimes and fracking rules, government-sponsored enterprises with a lower cost of funds crowding out private sector activity, changes in the interpretation of anti-trust rules, and shifts from capacity pricing to merchant pricing.
- Government action. Deregulation has proven to be just as disruptive as re-regulation, particularly as it relates to boom–bust cycles in telecommunications, utilities and broker-dealers.
- Foreign competitors whose market share is magnified by government subsidies and exchange-rate manipulation. China’s exchange rate management and subsidies to its auto, steel, solar, paper and glass companies are primary examples.
- Intellectual property infringement by domestic or foreign firms.
- The impact of patent trolls, which is estimated to cost U.S. businesses upwards of $20 billion per year.
- Changes in U.S. or foreign government tariff or trade policy.
- Fraud by non-executive employees, which according to SEC investigations from 1997 through 2007, accounted for about 30% of all instances. Also, fraud by employees or management in companies that are either the acquirer of or are acquired by a firm.
- Technological innovation that effectively provides consumers with enough information to bypass intermediaries and distributors.
- A shift in buying power to a firm’s customers resulting from consolidation.
- Unconstrained expansion by competitors, leading to a collapse in pricing power.
As you consider this list, think about how many of these events are predictable, even by the most senior of company executives. And think about how many more reasons Cembalest could have listed. And then, remember, that the future will provide still new reasons.
Before closing, we need to cover one more mistake related to concentrated positions: letting taxes dominate the investment decision. A good general rule in investing is that it usually doesn’t make sense to let the tax tail wag the investment dog. In the case of concentrated stock positions, this is usually (but not always) true because taxes need consideration given the treatment of low-basis stock upon death (it receives a step-up in basis). As a result, older owners of concentrated stock interested in reducing exposure have to take into account the potential tax cost involved with diversification.
Consider the example of my friend who had purchased Cisco at $5 and watched it rise to $80. In addition to the mistake of believing he was playing with the house’s money, he may not have been willing to sell because of the large tax bill. After watching it drop to $13, you can be sure he would have been happy to have sold and given Uncle Sam his due. One of my favorite sayings is that there is only one thing worse than having to pay taxes — not having to pay them.
The Bottom Line
Unless you are anticipating death in the near term, don’t be trapped into inaction by having to pay taxes. Even then, you should reduce risk by hedging your concentrated position by buying puts to protect the downside risk, or writing a collar (buying a put and writing a call that would bring in some further income while giving up upside potential). The tax bill should be thought of as a form of insurance that greatly reduces the risk of the portfolio.
Concentration brings both the opportunity for great returns and the agony of disasters. For investors who have a relatively low marginal utility of wealth and thus should be risk averse (having already “won the game” by achieving sufficient financial wealth to maintain a more than acceptable style of life), having concentrated positions is an imprudent risk. If you find do yourself with a concentrated position, don’t just sit there, trapped into inaction by the biases we’ve discussed, or one day you might find that you have turned a large fortune into a small one.