The portfolio management team works closely with advisors and our financial planning professionals to customize a strategy that appropriately manage concentrated stock portfolios by balancing three important, yet often competing, objectives.
First, holdings must be diversified or hedged to reduce the inherent risk of a large stock position. Second, capital gains taxes should be minimized or deferred as much as possible. Third, liquidity profiles must be tailored to meet the client’s spending needs and estate planning goals. Because each client has a unique combination of risk tolerance, tax circumstances, and financial goals, personalized planning is essential.
Investors and their advisors must also navigate a variety of behavioral biases when creating a portfolio management plan. Concentrated positions often result from long-term employment, inheritance, or an exceptionally successful investment— each of which can lead to strong emotional attachment to a particular stock. Attitudes toward taxes can further influence decision-making. Investors may fall into the trap of letting the “tax dog wag the investment tail” making suboptimal long-term decisions to avoid taxation. Additionally, there often seems to be no ideal time to reduce a concentrated position. A stock at all-time highs feels destined for more gains, while one that has declined seems likely to rebound to previous levels. Any of these factors can make a client reluctant to sell securities that have been responsible for a large portion of their net worth. Understanding a client’s feelings and preferences is a critical part of developing a sound plan.
Reducing Risk
Diversification is a key principle of portfolio management. Holding numerous securities across asset classes and geographies can reduce or eliminate company-specific risk—an essential consideration for any portfolio.
The most obvious risk of concentration is that an individual stock can lose most or all of its value. Many well-known examples of once dominant companies that fell victim to mismanagement or competition are plentiful. Enron, Lehman Brothers, Kodak, Sears, and General Motors are just a few examples of companies that were once market leaders but eventually declared bankruptcy. Clients holding stocks that have performed extremely well over time often underestimate this risk and such situations are admittedly somewhat unusual. Focusing too much on extreme situations can result in overlooking a much more important/probable risk— the risk of long-term under performance.
Unfortunately, even when a company does not meet an untimely end, it is still likely that an individual stock will underperform a diversified portfolio over the long term. In fact, most companies actually underperform an index over time, and many fail to keep up with risk-free U.S. Treasuries!1 This is due to the relentless nature of capitalism. Capitalism thrives on competition and highly profitable companies naturally attract the challengers. This makes it extremely difficult for a stock to continue outperforming for a long period of time. Of the 10 largest companies in 2000, only two have outperformed the S&P 500 index since then, while two lost most or all of their value. Since 2010, half of the ten largest firms have underperformed. Even since 2020, four of the ten biggest companies have lagged the index. The longer the time frame, the more likely that a past winner will underperform a diversified portfolio.
Another risk of concentration is the potential to miss out on future winners. Many are familiar with the role of the “Magnificent 7” (Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA, and Tesla) in market performance over the last decade, but fewer consider the contributions of firms like Eli Lilly, Cintas, Trane Technologies, and Progressive Insurance over that time period. A portfolio that did not contain these stocks would also be at a disadvantage to the market. Returning to the benefits of diversification, even many of the big winners in the Magnificent 7 suffered temporary drawdowns of 50% or more over the past decade.
Creating a Plan
Creation of a management plan for concentrated stock involves 3 steps:
- Advisors work with clients to establish a plan for spending needs, estate planning intentions, and any philanthropic priorities.
- Client preferences are incorporated into a long-term tax and risk budget.
- Portfolio management proposes a diversification plan utilizing a range of potential choices, including pre-planned sales, options based approaches, tax-loss harvesting techniques, and other appropriate strategies.
Because Fragasso’s advisors work closely with our portfolio management team on a daily basis, we are uniquely positioned to craft custom strategies for each client.
Effectively managing a concentrated stock position requires an objective evaluation of risk, a deep understanding of the client’s priorities, and a disciplined plan for diversification over time. Emotional attachment, tax considerations, and timing anxieties can cloud judgment, but these biases may jeopardize long-term outcomes. Through careful planning, thoughtful communication, and sophisticated portfolio management tools, our team can help clients transition from concentrated risk toward a more resilient, tax-efficient portfolio.
Source:
1 https://www.sciencedirect.com/science/article/abs/pii/S0304405X18301521?via%3Dihub
