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Concentrated stock risks

Last Updated:  April 13, 2016

Concentrated stock risks

Concentrated stock risks are risks you shouldn't be willing to take
There are many risks associated with owning concentrated stock positions. Are they worth it?

There’s a big difference between concentrated stock risks and simply owning individual stocks. Concentrated stock risks are relevant to investors with large portions of their investment assets tied up in a single company. There’s an amazing amount of risk associated with concentrated stock positions.

Concentrated Stock Risks  & Owning Individual Stocks

While you may not own a concentrated stock position, if you do own individual stocks the moral of the story is the same – the risk isn’t worth the reward. In fact, I’d argue your value is far worse with simply owning individual stocks than a concentrated stock position (such as working at Microsoft and owning a lot of MSFT shares). At least with a concentrated stock position you have a CHANCE to hit it “life-changing” big! When owning a portfolio of individual stocks you don’t really even have that. What you do have is all of the single stock risks without the potential for a big fat payoff.

JP Morgan did a study called “The Agony and the Ecstasy: The risks and rewards of a concentrated stock position“. They looked (from 1980 to 2014) at how and why companies were removed from the S&P 500 discounting things like mergers or re-incorporations outside the United States. They found that 320 of them were removed for “business distress” reasons. That’s amazing! That means that nearly 10 companies per year which make up the largest 500 stocks traded in the United States are kicked out of the S&P 500 due to business distress!

Then they went on to look at the broader stock market using the Russell 3000. Here’s what they found:

  • Catastrophic Declines – They found an astonishing 40% of companies had suffered a loss of 70% or more… and never recovered! Some sectors were far worse than the stock market as a whole.
  • Underperforming The Market – A whopping two-thirds of all stocks underperformed the broad index. On average, that underperformance was about 50%.
  • Diversification Would Have Helped – When looking at the optimal risk-adjusted returns they found that 75% of stockholders would have benefited from diversification.

Dear individual stock investor: Your stats are the same

The moral of the story is the stats are the same. Whether your position is highly concentrated and it’s a large portion of your net worth, or you just own an individual stock portfolio – your risk outweighs the reward.

Look at the odds no matter what companies you own – 40% suffered a catastrophic loss, and 66% underperformed the broad market index. Those are staggering odds, the same odds that prompted me (as a stock investor) to wake up and start investing in passive mutual funds in 2002 (that’s right, I haven’t owned a single individual stock position since 2002).

We have many clients who have a couple of stocks here and there. Over time they end up moving what’s left of those positions into their passive mutual funds as well (usually). I realize it’s super fun to try and invest in the right companies, and it’s neat to type a blog post on a MacBook knowing you own Apple stock! But the bottom line is I am typing this blog post on a MacBook and I do own Apple stock, the difference is I own it through a passive mutual fund where I’m guaranteed to roughly get the broad market returns (which you didn’t 66% of the time with individual stocks) and I’ll never experience a catastrophic loss of 70% or more (which 40% of individual companies have experienced).

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