Concentrated Stock Can Be Hazardous To Your Wealth

First, we must ask “What do we consider a concentrated stock position?” The rule of thumb is 10% of your investable net worth. Now, rules of thumb can sometimes get us in trouble, but the risk should be looked at from a holistic perspective.

For example: If you are in your 40’s you may be comfortable holding a bit more of company stock because your time horizon for retirement might be many years away. If your company stock under-performs you still have time to make up the lost ground with additional savings.

If you are near or in retirement, you may not want to hold any individual stocks at all, as now you are “playing for keeps” and don’t have time to make up the difference. Another factor you might consider is your overall net worth. If you have sizable assets but small expenses, you may be able to invest more aggressively with certain portions of you portfolio.

The chart below shows how risky individual stocks in the S&P 500 were from 2003 – 2017. First, let’s note that when the period begins there were 500 companies to choose from, but at the end there were only 314 companies. Companies leave an index for a variety of reasons, including the company going out of business, severely under-performing and being forced out of the index, or some sort of merger/acquisition event occurred. So, just some simple math; 314/500 = 63% of the companies are left in the index after that 15-year period.

Next, we should look at returns over that period. The S&P 500 Average Annual Return over that time period was 9.9% with a standard deviation of about 16%. Standard Deviation represents risk in this chart, and it is basically how much the price has swung over one year periods around the average price. You can see that few stocks beat the annualized return of the S&P 500, and the capital market line shows that the majority of individual stocks under-perform the index on a risk-adjusted basis.

What do these numbers tell us? Well, trying to identify great individual companies is very hard to do. That’s why we like to own the broad global markets and tilt our portfolios in favor of proven return premiums, such as: value, small-cap, and profitability.

Individual stocks could outperform the market with a much higher risk level. Alternatively, they could be one of the 186 stocks that are not even in the S&P 500 anymore. We believe taking calculated risks with a solid long-term investment philosophy is the way to go.

Source: Vanguard: The vanguard Advisor’s Alpha “guide to proactive behavioral coaching” Slide 24-25