The Agony and the Ecstasy: Risks and Rewards of a Concentrated Stock Position (Part 3)

When done properly, diversifying your portfolio can reduce risk without reducing its expected return. Yet, despite this financial “free lunch,” many individuals hold concentrated positions in a single stock when they could easily diversify away these idiosyncratic, single-company risks. That, of course, begs the question: Why do so many investors hold portfolios with heavily concentrated positions? The answer could simply be that many people don’t realize just how risky individual stock ownership is.

While we’ll focus on the issue of concentrated positions in individual stocks, the very same issues apply to mutual funds. For example, while investors can own a total stock market fund, many will invest in funds that own as few as 20 or 30 stocks. This same issue extends to mutual fund investors who neglect to diversify across asset classes or geographically, limiting their holdings to domestic mutual funds or only a small allocation to international stocks.

Individual Stocks Are Riskier than Most Believe

Building on reasons from last week and the week before that, another explanation for why so many investors fail to diversify involves the likelihood that many don’t understand just how risky individual stocks can be. I’m confident that most investors would be shocked at the following.

A study by Longboard Asset Management entitled “The Capitalism Distribution” which covered the period from 1983 through 2007 and the top 3,000 stocks found the following:

• 39 percent of stocks lost money during the period
• 19 percent of stocks lost at least 75 percent of their value
• 64 percent of stocks underperformed the Russell 3000 Index
• Just 25 percent of stocks were responsible for all the market’s gains

Investors picking stocks had an almost two-in-five chance of losing money, even before considering inflation. They had an almost one-in-five chance of losing at least 75 percent of their investment, again before considering inflation. There was just more than a one-in-three chance of picking a stock that outperformed the index. Do you really want to bet against those types of odds with money you will need to live off during retirement?

Let’s examine some other powerful examples of the risks of concentrated positions. The first is a look at the 500 firms in the original S&P 500 in 1957. By 1998, only 74 remained in the index, and just 12 of those 74 actually outperformed the index—that’s astonishing odds of failure.

The second example comes from the decade of the 1990s, which produced one of the greatest bull markets of all time. Despite the S&P 500 Index returning 18.2 percent per annum, producing a total return of almost 433 percent, 22 percent of the 2,397 U.S. stocks in existence throughout the decade had negative returns. And not negative real returns, but negative absolute returns. Even this shocking figure is inaccurately low. The reason is that it includes only stocks that were in existence throughout the decade—thus, there is a large survivorship bias in the data.

A third compelling example of the risks of single-stock investing is that, since 1980, there have been an astonishing 320 deletions from the S&P 500 Index that weren’t a result of a benign decision (such as the company being acquired at a premium). Joseph Schumpeter noted, capitalism is based on competition, creative destruction and reinvention.

Double Jeopardy

While concentrating investments in a single stock is imprudent, the mistake is often compounded by investors who further choose to concentrate their financial assets in their employer’s stock. As we discussed previously, an investor’s familiarity with their employer may cause them to believe that their firm’s stock is a less risky investment than, for instance, a globally diversified portfolio of mutual funds that contain thousands of stocks.

This is clearly a behavioral error, especially when we consider two potential outcomes. The first is one in which the company does well. If that is the case, the employee will also likely do well regardless of whether or not he owns lots of company stock. The outlook would be bright for pay increases, bonuses, promotions and perhaps even more stock options or stock grants. On the other hand, if the company does poorly the employee could face a double financial whammy. Not only will his portfolio take a devastating hit, but the employee may find himself without a job due to layoffs or even bankruptcy.

Concentrating assets by putting both your labor capital and financial capital in the same risk basket is playing a game of double jeopardy. And that’s why, while concentrating the two risks may provide the best chance of creating a fortune, it’s also the surest way to blowing the fortune. And prudent investors know that understanding the consequences of decisions should dominate the probability of outcomes, no matter how good you estimate the odds to be. That understanding helps avoid the behavioral mistakes we, as humans, are prone to make.

The Bottom Line

While diversification is clearly the prudent strategy, the potential for outsized rewards—however improbable—may sway some investors to take the lottery-like risk anyway and buy individual stocks. Next week, we’ll take a look at which outcome of holding a concentrated position is the more likely: the agony of big losses or the ecstasy of a huge payoff.