Boom or Bust? Managing Expectations for Concentrated Positions and Risk (Executive Summary)
Simge Ulucam, Harrison Selwitz, and Lisa R. Goldberg
Investors holding concentrated stock portfolios are exposed to company-specific risk, which has been associated with a high rate of catastrophic loss in the past. Diversification of the concentrated stock to a portfolio that tracks a broad market index reduces company-specific risk and may be beneficial even if liquidation of the position has an up-front tax cost. These conclusions are based on a comprehensive study of stocks that were members of the Russell 3000® Index at any time between December 31, 1986, and February 28, 2022.
For some investors, holding a concentrated stock portfolio was a boom-or-bust experience. Nearly 40% of stocks in the index faced a catastrophic loss, meaning a loss of more than half of their peak values without recovery. Catastrophic loss was prevalent across sectors with at least 30% of stocks in most sectors experiencing such a loss. Although companies of all sizes and market sensitivities carried this risk, smaller companies and those with higher market betas had a higher chance of catastrophic loss.
While most stocks underperformed the index, a few spectacularly outperformed. Within their respective lifetimes, only 34% of securities saw returns better than the index and only a small portion of those exhibited extreme outperformance, offering the rare chance for a big payoff on a relatively small investment when the share price rose significantly. Stocks that were in the top decile, as sorted by their lifetime cumulative returns over the index, had excess returns of more than 6,000%, on average.
An investor holding a concentrated position may wonder about what to expect in the future. Historically, past winners did not keep winning. Portfolios consisting of the 25 top outperformers over a 10-year period, on average, underperformed the index over the next 10 years. Among the headline stocks that were once extreme winners are several of history’s biggest losers, with examples including Yahoo! (collapsed and never regained its dot-com highs); Sun Microsystems (was more than 95% off its peak value), Sears (lost nearly all its starting value), and GE (experienced several bouts of catastrophic losses).
An assortment of diversification techniques offer protection from catastrophic risk while allowing investors who would like to keep a stake in a concentrated position to do so. Our study shows that reducing the level of single-stock concentration up-front through partial liquidation and investing the proceeds in the index lowered the downside risk associated with the overall investment. In addition, given that individual securities typically underperformed the index, at lower concentration levels, their relative weights in the portfolio naturally declined and with that, the likelihood of a catastrophic loss for the overall portfolio.
For taxable investors, liquidating a concentrated stock can pose a significant tax hurdle, especially if it is highly appreciated. Diversification may still be beneficial for such an investor. Given that the median security lagged the index by more than 5% per year during our study period, a typical investor would have offset the liquidation tax cost by investing the after-tax proceeds from the liquidation in the index for six years, based on our stated assumptions.
Although diversifying a portfolio does not guarantee profit or protect against investment loss or market volatility, reducing the level of single-stock concentration can lower the downside risk associated with that position. Given the general tendency of single stocks to underperform the market historically (including facing unrecoverable catastrophic losses), investors would be prudent to shift their focus to manage risk, diversify, and avoid the boom-or-bust experience.
To learn more about the risks associated with a concentrated stock position and how diversifying might mitigate them, read our complete “Boom or Bust?” paper.
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