Tips to Reduce Concentration Risk

Today’s article is a bit more detail into one of the more popular podcasts I have recorded to date. The topic is Concentration Risk. I’ve already covered what exactly is Concentration Risk. Today we will talk about some specific strategies to reduce Concentration Risk.  Let’s get to it. 

The simplest definition of Concentration Risk is the amount of risk by investing in one position. I guess you could say by investing in a few positions, but we are going to focus on just one position as that is what I see with clients who have Equity Compensation positions. I’m not going to get into a more complex definition of Concentration Risk as I don’t think anyone really cares.  Instead, I am going to ask you my favorite Concentrated Risk question. 

If you were not a current employee of this company, how much of their stock would you own in your portfolio?   No right or wrong answer here. But take a minute or 100 to think about this because it is important. 

A couple more things to mention before we jump into the actual action items to reduce your Concentration Risk. First, this happens over time. I compare it to the story of the frog in a pot of boiling water. Short version is if you put a frog in a pot of water and slowly raise the temperature it will not notice it is boiling to death. However, if you drop a frog into a pot of already boiling water the frog will jump out. Personally, I don’t think the story is true, but you get the point. 

Concentration Risk grows over time. You start buying a few shares through your Employee Stock Purchase Plan, then are awarded Restricted Stock Units, Restricted Stock, and maybe some Non-Qualified Stock Options. And suddenly you’ve been receiving these positions for 20 years without ever paying to it the attention it deserves. Now half or more of your net worth is tied up into one stock.  Yikes! 

The second and final point before I get to the strategies is just a reminder of how stocks perform. Stocks don’t always go up, even if you believe in your company and deeply want the price to go up. We all know the horror stories of Enron going bankrupt. But there are other quieter stories of companies like IBM, GE and Altria. While they haven’t gone to zero, they have lost quite a bit of their value from recent highs. At least last time I checked. 

I would be remiss if I didn’t also mention just because your company stock continues to go up that Concentration Risk isn’t still an issue. Maybe you work for Sherwin-Williams or Procter and Gamble. Both of these companies and their stock price have done exceptionally well the past few years. In these cases, having great stock growth can easily result in having what was 30% of your net worth in one stock to now be over 50% in a few good years. Simply, Concentration Risk occurs when stock goes up or down. 

Alright, enough background. Let’s talk some specific tips to reduce your Concentration Risk. This is what you came here for, right? 

First tip is to look at the forest. In this case, I mean your entire net worth and where you are invested. Basically, we are trying to see how well you are diversified. Oh, before I forget, there will be some overlap here. Forgive me, but some things are so important they will come up in various tips. 

Back on topic. I want to make sure you do not have all your investment eggs in one basket. You know, maybe you are the Sherwin-Williams lifer who is nearing retirement and just discovered 60% of your net worth is in Sherwin-Williams. And, you have answered the magical question that you would be comfortable owning that much even if you were not an employee of the company. Cool. Now, it is time to turn to the other 40% of your net worth and check to see how diversified it is. 

Here you should be looking at things like do you have other equity, or stock, positions. If so, how is their correlation to your Sherwin stock. You know, do they all move in the same direction at the same time? If this is the case, you may want to find some holdings that complement your Sherwin positions. This goes the same for bonds, also known as fixed income. 

It doesn’t take a ton of positions to provide proper diversification in your portfolio. Studies show after you get over a couple of dozen holdings the effects of diversification drop. However, you need to make sure they are the right positions doing the right thing. And, because you have a concentrated position in one stock building out a diversified portfolio can get more complex. 

The second logical step, and maybe a subpart of the first tip, is to spend a bit of time looking at the specific holdings you own. Simply, you are starting to peel back the layers of the holdings in your diversified portfolio. Most of us own mutual funds or ETFs. This means we do not own individual stocks and bonds, like your company stock. Because of this, we need to spend a bit of time figuring out exactly what else you are holding. 

The reason is because the world of investment management likes to make itself more complex than it needs to be. Well, maybe that is a bit too cynical. Regardless, many of these investment products, such as mutual funds and ETFs, are rather opaque. I would hate for you to own a certain ETF thinking it is a nice balance to your concentrated position in company stock and then find out the hard way they are actually two highly correlated investments. Basically, the ETF you bought to balance out the risk is instead adding to it. 

Another example is the world of Target Date Funds. Many people found out the hard way in 2008 these were not all the same. The basic concept with these mutual funds is you picked one with a set date and they would get more conservative as you came closer to that date. So, maybe you were planning to retire in 2010. And you thought your target date fund would go to all cash as you were getting closer and closer to 2010. Reality was some target date funds went all cash, but most were still 40 to 50% in stocks. Their approach was you would still be investing for decades. 

The lesson here was to not assume how an investment actually was designed just based on its name. It takes time and a bit of work on your part to verify how your other investments are working and look at them in a bit more detail to make sure they fit in the whole picture.

 Oh, I should also mention to consider how liquid your other investments are. Just in case you invest a large portion of your non concentrated company stock into something like an annuity, a private real estate investment, or a structured note, it is important to know how liquid and readily accessible those funds are in case you need them.   

A third tip, and I promise this will be a brief one, is to determine what percentage of your overall holdings you want to hold in your one concentrated position. You know, are you comfortable with having 70% of your net worth in your company stock or is 30% the highest you want to be. I would recommend getting with your CFP® to determine which level is right for you. 

Now that you have identified that percentage it will help guide your overall investment approach and is key to the final point. I told you it was a brief tip. Of course, holding true to this number is a whole other story. You know, if you say you won’t hold more than 50% in company stock and the stock is doing really well it may be harder to maintain that 50% level. 

Your final tip is to rebalance. I’m sure you know what this is, but just as a refresher, it is key to identify how much you wish to hold in what positions. This is where the previous tip about identifying how much you will hold in your company stock comes into play. Now that you have figured out that number you can start determining the other appropriate percentages. 

Just to keep this simple, let’s say your concentrated company stock number is 50%. You and your CFP® have identified your overall stock allocation is 60% and the rest is in bonds and maybe cash. So, you have another 10% in other stock holdings and the final 40% goes into bonds. 

Now that you have those percentages identified it is up to you to decide on what basis you will rebalance. There are various approaches here. You can rebalance based on performance. For example, if the company stock does well and goes from 50% of your portfolio to 58%, you may need to sell 8% of those gains and put the proceeds into those holdings that have not done as well. 

Another approach to rebalance is to do it based on a time. Many advocate for rebalancing once a year. Maybe your first action of the new trading year will be to sell and buy your various holdings to get back to your overall 60/40 allocation. 

Now, I would love to tell you one approach is better than the other. I can find studies to prove both approaches make more sense than the other. Personally, I fall into the percentage rebalance camp. Ultimately, what it comes down to is to having a disciplined investing strategy and following it. 

Alright, this seems like a good place to stop with a few tips to reduce Concentrated Risk. Hopefully this has been helpful. As always, if you are wondering what is going on with your equity compensation, do not hesitate to reach out and schedule some time to talk. 

As always, thanks for taking the time to read this. Please do not hesitate to reach out if I can be of help with your equity compensation-related questions. The easiest thing to do is to click the little green box that reads “Schedule a Meeting” that can be found at the bottom of every page on my website. Or, just click my Calendly link right here.