The Risks of a Single Stock Concentration

Stocks & Bonds | Stock Options

 Plancorp Team By: Plancorp Team

Say the word “investing” and a lot of people automatically think of buying individual stocks. Even though the stock market isn’t the biggest financial market out there—that would be the bond market—it’s the one that gets the most attention. As a result, people tend to gravitate toward stock investing, and sometimes that means they end up with a portfolio that’s overloaded with one or two names. 

Single stock concentration can happen for different reasons. For starters, there’s a lot of temptation out there to buy individual stocks. Investors may want to hop on the bandwagon when they see a big winner or hear a recommendation from a knowledgeable person with a compelling idea. On the other hand, when markets are down broadly, it can feel like blue chip names are on sale and it’s time to load up on shares.  

You can also end up with concentrated stock positions without even realizing it. For example, if you receive company stock as part of your compensation and you haven’t sold any shares yet, you may be surprised by how much of your wealth is tied up in your company’s shares. 

Whatever the reason, a concentrated position in a single stock introduces large amounts of unnecessary risk to your portfolio. Learn more on why by reading below.

Picking Good, Strategic Stocks

You may believe you’re more skilled than the average investor at picking stocks. You might understand a particular industry and think you know which companies are better than others. Or you feel you’ve spotted something that everyone else is missing. Maybe you’re just comfortable holding a lot of your own company’s stock because you're confident about its future — and even feel that your hard work has a direct influence on the stock price. 

In either case, the odds of success from investing in single stocks are a lot lower than you think. It’s extremely unlikely that you’ll find a stock that beats the market. Consider the fact that it’s nearly impossible even for professional investors.

In 2021, 85% of actively managed large-cap funds trailed the S&P 500, according to SPIVA U.S. Year-End 2021. These are teams with access to vast amounts of data. They talk to people inside the company. They talk to the company’s suppliers and customers. They talk to competitors, economists, and analysts. Despite having so much information at their disposal, the vast majority of these funds fail to outperform the overall market.

Why is it so difficult for you or the professionals to pick winners? You’re betting against the collective knowledge of the financial markets. Millions of people and institutions are buying and selling stocks every day. They’re reacting almost instantly to any bit of information (positive or negative) that could influence a company’s stock price. For that reason, stock prices largely reflect all available information about a company and the collective wisdom about its future prospects. 

Choosing to hold an individual stock is tantamount to saying that you have better information than the collective. So rather than compete against this knowledge, it’s far better to harness it by investing in broadly diversified funds that track the market.

Investing in Individual Stocks

Risk and return are related. When you take on more systemic risk — the risk inherent to the market at large — you are rewarded with higher expected returns. However, you are not compensated for idiosyncratic risk, or the risk associated with an individual company. 

Any single company might go bankrupt, cause an environmental disaster, get involved in a scandal, or even simply fall out of favor with investors. And if your concentrated position tanks, it can bring down your portfolio with it. This is a real possibility when you realize that 40% of all companies in the Russell 3,000 experienced permanent decline of 70% or more from their peak. 

Even if the stock you pick doesn’t tank, the returns for most individual stocks trail the performance of the market overall. Research from Vanguard found that the median return for the individual stocks that make up the S&P 500 was 10.9%. That might sound good until you realize that the return for the S&P 500 overall was 13.9%. 

Again, investing in broad market funds for the long-term is your best bet. And while that may seem boring, good investing is inherently boring—if it’s not, you’re probably doing it wrong.

How Much is Too Much to Invest in One Stock?

If you must invest in an individual stock, it’s best to think of it as entertainment. Hold individual stocks in a separate account from your other savings and avoid having more than 5-10% of your overall assets tied up in concentrated stock positions. 

Why so little? It comes down to the fact that for an individual stock to change your life, your bet would have to be irrationally large. Given the low probability of picking a stock that outperforms the market as a whole, making large bets is a bad idea. If you choose incorrectly, you could potentially see a large amount of wealth wiped out in a short period of time.

What to do if You Have a Concentrated Position

If you’re overly concentrated in any single stock, it’s best to slowly diversify out of that position in a tax-efficient manner. You may use options to hedge against downside risk while you create more diversified exposures. Or you could use direct indexing strategies that focus on tax loss harvesting and use capital losses to offset gains while you diversify out of concentrated positions.

And if you receive company stock as part of your compensation package, think of it as compensation — not some special token you need to hold— and sell new awards immediately. It’s more capital efficient for companies to compensate you with equity than cash, but that doesn’t mean they want you to keep the stock forever.

Finally, remember that selling appreciated stock may result in capital gains, which could bump you into a higher tax bracket or carry Alternative Minimum Tax (AMT) implications. So it’s important to consult with an advisor to manage taxes as you diversify your portfolio, and then sit back and let the market do the work for you.

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This material has been prepared for informational purposes only and should not be used as investment, tax, legal or accounting advice. All investing involves risk. Past performance is no guarantee of future results. Diversification does not ensure a profit or guarantee against a loss. You should consult your own tax, legal and accounting advisors.

Plancorp is a registered investment advisor with the Securities and Exchange Commission ("SEC") and only transacts business in states where it is properly registered or is excluded or exempted from registration requirements. SEC registration does not imply a certain level of skill or training. Please refer to our Form ADV Part 2A disclosure brochure and our Form CRS for additional information regarding the qualifications and business practices of Plancorp.

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