Working as a financial advisor is part science, part art. Often we deal with situations where there is a clear theoretical rationale for taking an action…but doing so might cause extreme discomfort to our clients. The art comes in devising a compromise that will not only fulfill our fiduciary duty, but will do so in a manner that the client can live with.
Dealing with concentrated positions is one of the premier examples of this phenomenon. The theoretical directive is clear: the client should diversify immediately. Having too many eggs in one basket presents a significant risk to a client’s financial well-being. Here’s just a couple of examples that corroborate that assertion:
- In the 1980s IBM was thought to be a “can’t miss” investment. Investors felt confident holding huge positions in the stock; 20%+ allocations were common. The rude awakening came in 1987–1993 when the stock price plummeted 50%. It took more than ten years for IBM’s stock price to recover to its 1987 peak.
- In September 2001, the attacks on the World Trade Center had a severe impact on blue chip companies such as Boeing and American Express. These great companies did recover fully, but the decline was sudden, and completely unexpected.
So, given these preceding examples, why would anyone hesitate to diversify a concentrated position? Here are some of the stumbling blocks, and some potential solutions:
- TAXES: Often concentrated positions have large embedded gains that when triggered, can result in a substantial tax bill. Taxes may be one of life’s only certainties, but still, the thought of signing a large check to the IRS doesn’t make anyone happy. Systematic selling that takes place over multiple tax years helps some investors get over this hurdle.
- STOCK LOYALTY: Often, investors get attached to stocks in their portfolio…particularly those that have done well for them over the years. I found this with Microsoft and Intel shareholders in the early part of this decade. (Of course, that loyalty began to erode after multiple years of poor performance, but by then, the damage had been done, and much of the embedded gain had been lost.) If you are holding a stock to which you have an attachment, remember that investing is not an all-or-nothing game. You can still keep a healthy position in your favorite stock, while redeploying your profits elsewhere.
- COMPANY LOYALTY: Investors who worked for a particular company are often reluctant to sell their shares in the company stock. Again, I encourage clients in this position to maintain an allocation to their company’s stock, but remember the Enron experience, and keep their position to a reasonable size.
- FAMILY LOYALTY: I often see this with people who have inherited their stock from a loved one. They feel as if selling the stock is disloyal to the loved one who made the initial investment. This is a tough situation, particularly when the person in question is still in throes of deep grief. The rational argument, that this is a financial issue, not an issue of love, is rarely helpful to someone who is suffering. If you find yourself in this position, know that “later” is a better answer than “never.” Your portfolio manager will nudge you towards diversification, but will do so with an understanding that you may not be ready just yet. Over time, you may find that you feel more comfortable making portfolio changes.
If you have a concentrated position, and you’ve been reluctant to discuss it with your portfolio manager, don’t be. She or he will understand if an “all-or-nothing, rip-the- bandage-off” strategy is not for you. Together, the two of you can devise a strategy that not only meets your tax tolerances, but also addresses any “softer concerns” you may have.
The views of the authors of these articles do not necessarily represent the views of First Republic Bank.