What Investors Should Know About Concentrated Wealth

When it comes to getting rich, there are essentially two avenues someone can take (aside, of course, from the dumb luck of winning the lottery). The first is leverage, when you borrow money to purchase more of something in the hope that its value will grow. The second is extreme concentration, where you bet on a single asset such as a baseball card, an apartment building, or, for our purposes, stock.

Unfortunately, having a concentrated stock position is also an easy way to lose money, as it can expose you to significant volatility. Overconcentrating your portfolio can happen in a number of ways. Perhaps you bought shares of a stock over time, or were compensated by your employer with shares of the company’s stock. For business owners, perhaps you invested a significant amount of your money in your own business. Whatever the case, it creates extra risk for you.

Let’s explore what this means for investors and what moves they can make to diversify their portfolio.

Why This Happens

For investors, falling in love with a single stock is all too common. A generation ago, it was Cisco, Dell, Qualcomm, Sun Microsystems and a host of others that became popular, then experienced a rapid decline in value when people realized clicks wouldn’t pay the bills.

Similar instances happen year after year. Household names like Kmart, Lucent, Nortel, Enron, GM, GE, CenturyLink, Sears, Carvana, Zoom and, most recently, GameStop have all experienced declines of 50% or more in recent years, showing the danger of investing too heavily in any one stock.

Large companies aren’t immune to this, either. When you look at the top 10 companies by decade, new leaders regularly enter the top 10, and old ones routinely exit. Thirty years ago, it was hard to imagine IBM, GE, Exxon and GM all falling out of the top 10, but it happened – and in some cases rather swiftly.

Even though there are plenty of historical cases outlining the dangers of portfolio overconcentration, why does this still happen? I’d argue it primarily occurs for several reasons:

• Investing in the market can feel overwhelming for an average investor, so only buying shares of a single company is an easy move to make.
• It can be comforting to buy shares of a business we’re familiar with. If we support a favorite brand by owning their product (think cars, phones, etc.), then owning their stock seems like a logical next step.
• We simply love it when their stock goes up. Unfortunately, this can create a dangerous reinforcement cycle. We feel good when the stock goes up, then feel smart that we bought the stock in the first place, so we continue to buy more, and the cycle repeats.

Moves to Make

For investors who’ve built a portfolio that’s concentrated too heavily on any single asset, there are strategies you can take to make your portfolio less risky and potentially marginalize your tax implications. A few of the solutions are simple, and a few are more complex, but in general they revolve around creating a game plan and limiting your emotions. Strategies could include:

• Rules-based position management, which involves making systematic sales to reduce exposure
• Positioning hedging
• Advanced tax strategies
• Gifting shares of stock to family and/or your favorite charities
• Taking advantage of the 2017 Tax Cuts and Jobs Act before it sunsets at the end of 2025

The approach you take will depend on your specific situation. Bell Bank Wealth Management can work closely with you to help develop a plan that’s appropriate for your portfolio.

This article was published in the Q3 2024 issue of the Bell Wealth newsletter.