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3 Misconceptions of Concentration Risk Thumbnail

3 Misconceptions of Concentration Risk


I wanted to talk briefly about a boring, yet extremely important topic today. Concentration Risk!   I see this most frequently with clients who have equity compensation. You know, things like nonqualified stock options, restricted stock units, restricted stock and even employee stock purchase plans. However, it is something every investor should pay attention to. 

The simplest definition of Concentration Risk is it is the amount of risk an investor takes by investing in one position. As a CFP®, I of course have to make the definition a bit more complex. It is the added risk you take when you fail to diversify your risk of loss without enhancing your prospects for long-term success. Basically, you are taking on additional risk without being compensated for it. 

When it comes to equity compensation holders, I think of the old story about the frog in a pot of water. If you drop a frog into a pot of boiling water it will jump out. However, if you put it in a pot of cold water that slowly increases in temperature the frog will stay in and boil to death. I’m pretty sure this isn’t true, but it is a useful illustration. 

For equity compensation holders, Concentration Risk seems to appear suddenly, but it has been coming to a boil over the years. This is through the continued accumulation of company shares via the various forms of equity compensation I mentioned earlier. If they step back and take a look at their equity compensation they may realize it is 40%, 50% or more of their net worth. 

We all know about companies such as Enron. They went bankrupt and everyone was wiped out. But what about a more traditional Blue Chip company such as General Electric? GE has gone from $60 20 years ago to around $11 as I write this. And that is without any splits in stock. IBM, another bluer than blue chip, reached its peak around $215 about 7 ½ years ago and has gone nowhere but down since to its current level in the $130 range. The final example is one of the top 10 performing stocks of the last 30 years – Altria. In case you aren’t familiar with the name, they make tobacco-related products. Around 3 ½ years ago Altria hit its high of about $75. Since then, yep, same story – it has only gone down. Their value is around $41 a share now. 

There is one question every owner of equity compensation (company stock) needs to ask themselves. If you were not an employee of this company, how much of their stock would you own in your current portfolio?   There is no right or wrong answer here, just think about it. 

Enough background. Let’s cover a few common misconceptions that exist with it. 

The first misconception is safety. Equity compensation holders often believe their company stock is safer than any other stock. Heck, many people believe it is safer than a well-diversified portfolio of stocks. I totally get this belief. Who wants to believe the company they have worked at for years may not be a solid company? It is like the old joke from Lake Wobegon where all the children are above average. 

Another misconception deals with analyzing the stock. There’s a joke in my world that if a stock misses what the analysts expected it isn’t the fault of the analysts, but instead the fault of the stock. This does make sense in the aspect of even the best and most competent analysis of a company’s stock doesn’t prevent a stock from going down in value. So, just because you have a team of the best analysts working on a stock it still has risks associated with it. 

Finally, the third misconception is by paying an overt amount of attention to one stock it will keep it going up and up. Let’s look at a perfect example of this. The best performing stock of the last 30 years is Amazon. If you had put $10,000 into this stock on its IPO in 1997 it would have been worth over $21 million at the end of November 2020. However, if you had invested $100,000 in December 1999 and watched it constantly, I bet you would have jumped ship. Why? Well, because no amount of watching Amazon in 1999 would have kept it from losing 94% of its value over the next two years. Your $100,000 would have turned into $5,570. 

One last point to make with Concentration Risk. It is a double-edge sword. Or what one might call a lose-lose situation. This is if things go poorly at your company not only may your stock value in your equity compensation plan be at risk, but how safe is your employment status? Seriously. Talk about kicking someone when they are down. Your stock drops and you may be out of a job. Ughh. 

Enough about Concentration Risk. In a future article I will provide some suggestions to help mitigate Concentration Risk. In the meantime, with the market near all-time highs and the start of a new year, it may be worth taking inventory of your investments to see how much Concentration Risk you are dealing with. Again, I see this often with my equity compensation clients, however, it can just as easily happen to someone who bought $10,000 of Apple a decade ago. Or maybe Bitcoin a few weeks ago😉