By CASEY TINIUS / CFP®
In many aspects of life extreme concentration is a good thing. Being able to lock in and focus on the task at hand is an underrated skill. While this trait might be enhancing your performance at work or in your personal life, extreme concentration might not be a good thing when it comes to your investment portfolio.
Having a concentrated position in your investment portfolio means you have a large percentage of your assets tied up in one position or company. Our rule of thumb is to never have one individual holding make up more than 5% of your overall portfolio. While this rule sounds reasonable it is important to have a strategic plan for decreasing concentrated positions.
Let’s dive in to a quick example. Client A came into our office 5 years ago with their company stock making up about 40% of their overall portfolio. The stock was a traditional blue-chip company that pays a 3% dividend and the client was able to purchase shares at a discount over the last 20 years so their basis was very low. Immediately getting this position down to 5% of the client’s overall portfolio would have resulted in a tax bill of around $100,000, which obviously would not have been in their best interest. Instead, we came up with a plan to sell 115 shares of the stock each quarter over the next 5 years until the client retired. It didn’t matter if the stock was up 10% or down 10%, we were going to sell 115 shares per quarter to begin lowering their overall exposure to the company. How did we determine the number of shares to sell you might ask? Selling 115 shares per quarter would put us at exactly 5% of the client’s assets assuming the company continued growing over the next 5 years.
Five years later when the client reached retirement the company now made up 7.5% of their portfolio due to their higher than expected stock performance. While we didn’t get to our 5% target we were comfortable leaving things at 7.5% given the quality of the company.
Why was it important to do this? Concentrated positions are great when the company performs well and could have led to our client grossly outperforming the market. In reality, this can work in the exact opposite way as well. How do you think our client would have felt if the S&P 500 was up 10% but his account was down for the year because his company was in the midst of a 30% drawdown for some unforeseen reason? What if company management took things in a bad direction and bankruptcy was a possibility meaning 40% of Client A’s assets could disappear? Our client didn’t want to take that risk so we developed a plan to minimize their tax burden and slowly decrease their overall exposure to the company.
If a concentrated position is unavoidable, come up with a plan to manage around it. The phrase “Don’t put all your eggs in one basket” fits this topic perfectly. If you picked Amazon as your concentrated position 20 years ago, all we can say is congratulations on your early retirement! If your concentration was in GE, unfortunately you may not ever retire.
Having your portfolio concentrated in one position can work out great if you pick the right position, but is it really worth the risk of having it work in the opposite direction?