Equity Concentration and Your Retirement
Evaluating Concentration Risk in Your Portfolio and Identifying Ways to Diversify It
There is an oft-cited saying in investment management circles , “Concentration builds wealth, diversification preserves it.” As you approach retirement, it is important to identify and evaluate the concentration risk that may have developed in your portfolio, and identify ways to diversity it.
What is diversification?
Wikipedia defines diversification as, “the process of allocating capital in a way that reduces the exposure to any one particular asset or risk.” This is a more erudite spin on the age-old adage, “Don’t put all of your eggs in one basket.”
For those approaching retirement, diversification means investing in many asset classes, as opposed to owning a large equity position in a single company. In a year that saw electric car company stock surge 695%, it is tempting to throw caution to the wind, and invest it all in one or two of the outperforming juggernauts. But as anyone who went through the 2000 tech bubble can attest, these high-flyers can come crashing down. If you have a significant portion of your wealth invested in just one, the risk to your retirement savings can be great.
How do equity concentrations form?
Concentrations can develop in several ways.
Investors may choose to hold just one company’s shares.
Executives are prone to have outsized positions as a result of their employer’s equity-related compensation programs.
Investors who have held on to 1 or 2 well-performing stocks or funds have seen a concentration occur as a result of the underlying asset performance.
Investors who have multiple investment accounts may be holding the same name in different accounts and may have lost track of the size of the combined position relative to the portfolio as a whole.
Holders of various mutual funds or ETF’s may hold concentrations as a result of different funds holding positions in the same company.
Some funds have equity concentrations by their varied nature. For example, Investopedia recently released an article that stated the top 10 names of the S&P 500 made up 27% of the index’s market value. In an equal weight index, these shares would comprise 2% of it.
Concentrations can develop in any number of ways, so it is important for investors to remain vigilant.
Identifying Concentrations
Investors can identify concentrations by reviewing their statements periodically. If positions are held in multiple accounts, it may be worthwhile to create a simple spreadsheet to consolidate all of the accounts and the underlying positions. Most brokerages provide a download of account positions in a CSV file which is easily converted to a favorite electronic spreadsheet format. Downloading this information can save a lot of time and keystrokes.
If an investor has significant positions in mutual funds and ETFs, there are free portfolio X-Ray tools that look through the mutual fund and ETF wrappers and analyze the individual positions in each. This helps identify concentrations that may exist as a result of multiple funds owning the same company’s stock. It is possible to do this manually by looking at the top 10 or so positions in any fund, however this process is very manual and can be time consuming. To obtain this information, go to the related fund’s website and look for the holdings section. (Alternatively, searching the term “(fund symbol) holdings” in your favorite browser may point you in the right direction.)
Reducing Concentrations and Related Considerations
For individually held positions, reducing the concentration can be as easy as divesting shares. There is a potential drawback, however. If the position has appreciated significantly and is held in a taxable brokerage account, selling shares may trigger income tax. Should you do decide to sell shares, make sure you have a strategy to identify and minimize the related taxable gains.
A second option is to donate the highly appreciated shares to charity. This allows you to divest the shares but does so in a very tax-efficient manner. Consult with your Certified Public Accountant before deciding if this strategy is right for you.
A third option is simply moving away from single stocks and investing in broadly diversified mutual funds and ETFs. By owning hundreds, if not thousands, of different companies in a mutual fund or ETF, investors can substantially reduce their potential for concentration risk.
A fourth option is to periodically rebalance the portfolio. Rebalancing involves selling the outperformers and buying the underperformers. While this may sound counter-intuitive, doing so will ensure that the investor maintains the asset allocation percentages decided upon when the portfolio was initially constructed. Doing so on a regular basis will help eliminate significant concentrations before they develop. But as noted above, when selling shares be mindful of possible income tax consequences.
More complex strategies also exist. Options strategies can effectively hedge single stock equity concentrations. If selling shares is legally disallowed, borrowing against the shares to diversify may be an option. (Using leverage introduces an entirely different set of risks into a particular situation). These strategies can be complicated. Consult a professional prior to implementation.
Summary
Preventing equity concentrations can preserve an investor’s wealth. It is important for investors to monitor their portfolios and manage concentrations as they develop. If concentration risk exists, investors should take the appropriate action to reduce their exposure and help preserve their wealth as they head into retirement.
About the author:
JP Geisbauer is a Certified Public Accountant and a Certified Financial Planner ®. He is the founder of Centerpoint Financial Management, LLC, a retirement planning, investment management, and tax planning firm located in Irvine, CA. If you have specific questions regarding your situation, please schedule a complimentary 30-minute call here.
Disclaimer:
This article is for general information and educational purposes only. Nothing contained in this article constitutes financial, investment, tax, or legal advice. Before taking any action on any topic discussed in this article, please consult with your financial planner, investment advisor, tax professional, and/or attorney for advice on your specific situation.