A Concentrated Stock Position Is a Lottery Ticket

Active Tax Management
May 5, 2021

An investor might hold on to concentrated stock for a variety of reasons. A position may carry a substantial tax overhang, or perhaps it has emotional value, representing the fruits of hard work building a successful business. Investors are subject, in greater or lesser degrees, to the “endowment effect,” which is our tendency to overvalue that which we already have.1

Still, the uncompensated risk2 in a concentrated stock position may prompt an investor to transition to a diversified index. We can see the nature of concentration risk by looking at the fates of investors who held different concentrated large-cap positions for a decade. Beginning with January 1, 1976, we calculated 10-year cumulative active returns3 of megacaps, the 25 largest stocks in the S&P 500 Index, on an annual basis.4 Figure 1 shows the range of returns on each date. The typical, or median, active return was negative in two-thirds of the 10-year periods we examined, and it varied from –130% to +51%. The 25th percentile active return was negative in every 10-year period in our sample. In the 10-year periods ended in December 2019 and 2020, the 75th percentile was negative. This reflects the performance difference between the high-flying FAAMGs (Facebook, Amazon, Apple, Microsoft, and Google) and most other stocks.

The maximum and minimum active returns shown in Figure 1 reveal the lottery-like silhouette of 10-year active returns of mega-capitalization stocks in the S&P 500. For example, over the decade that ended December 31, 1991, Texaco’s active return of -54%, received by our median investor, was dwarfed in magnitude by the outperformance of 1,462% enjoyed by an investor who held Philip Morris. In order to have fully benefited from that position, however, an investor would have had to bet on January 1, 1982, that Philip Morris would outperform over the subsequent 10 years. Some lotteries feature the tag line, “you’ve got to be in it to win it,” but lotteries rarely mention the fact that hardly anyone does.

Unlike a lottery player, a public equity investor has the opportunity to track diversified indexes, which are influenced, of course, by the best-performing stocks. The scatter plot in Figure 2 shows that, on average at a 10-year horizon, the S&P 500 return was approximately 25% of the active return from the best-performing stock in our study. No foresight required.

Figure 1: Distributions of 10-year cumulative active returns to the 25 largest stocks in the S&P 500 Index. Sources: Aperio and MSCI. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass.

Figure 2: Linear approximation of the relationship between 10-year cumulative return for the S&P 500 Index and the 10-year cumulative active return for the best-performing stock among the 25 largest stocks in the S&P 500 Index. The slope of the best fit line is approximately 0.25. Sources: Aperio and MSCI. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass.

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1 The endowment effect was formulated in Richard H. Thaler, “Toward a Positive Theory of Consumer Choice,” Journal of Economic Behavior & Organization 1, no. 1 (March 1980): 39–60.
2 Hendrik Bessembinder, “Do Stocks Outperform Treasury Bills?” Journal of Financial Economics 129, no. 3 (2018): 440–57. Michael Cembalest, “The Agony and the Ecstasy: The Risks and Rewards of a Concentrated Stock Position,” J.P. Morgan Eye on the Market (2014).
3 Active return is the difference between portfolio and benchmark returns.
4 On occasion, the 10-year return to one of the 25 largest securities was unavailable due to a merger, an acquisition, or another event. In our dataset, there were 91 such securities, and never more than seven on a single date. The number of such stocks declined over our study period, and it was equal to 0 in the three most recent periods.


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