Are you putting all of your investment eggs in one basket? Learn how to invest without the risk of losing all your assets at once.
Concentrations: Putting All Your Eggs in One Basket Can Scramble Your Investment Goals
Last weekend, I visited one of my favorite brunch spots in Louisville, Con Huevos!, and their popular Huevos Rancheros dish has been on my mind ever since (outside of the markets of course!). With that, a subtle warning: this edition of First Bankers Notes is filled with terrible egg puns that you likely won’t find runny (I mean funny!), but the underlying message is important.
The popular proverb, “Don’t put all your eggs in one basket”, can be traced back to the early 17th century Spanish novel, Don Quixote, written by Miguel de Cervantes. Unknown to many, this masterpiece has been translated into more languages than any book outside of the Bible. Don’t worry, I was shell shocked too!
In the investment world, having ‘all your eggs in one basket’ is something we investment yolks would describe as Concentration Risk, meaning that the value of your total wealth might be overly dependent upon the value of an individual asset such as a certain stock, a certain sector of the stock market, or perhaps even a certain type of investment asset class altogether such as gold or, for the millennials out there, Bitcoin. An egg-lovin’ investment manager might call that being…undiversi-fried?
Concentrations typically hatch and grow over time due to a variety of circumstances. While some might acquire an ample number shares via an inheritance, others may receive company stock in the form of employee compensation. Concentrations can also develop ‘over easily’ through strong price appreciation of a stock relative to the rest of their portfolio. From an individual stock perspective, we view having 10% of your total portfolio tied to a single security as a concentration.
When stocks grow into large concentrations with large gains, behavioral biases and an unwillingness to pay Uncle Sam in the form of capital gains tax naturally take over. A hypothetical, but not uncommon, client conversation:
Advisor: “Your Molson Coors stock (NYSE ticker: TAP) stock has done really well over the last seggeral years and has become 25% of your overall portfolio. We should consider locking in some of those gains and diversifying into other stocks, as your total wealth is becoming highly dictated by your position in TAP.”
Client: “Did you just say seggeral instead of several?”
Advisor: “Yes, I’m sorry. Anyway, what are your thoughts on lessening your concentration to TAP stock?”
Client: “Are you kidding?! I’ve got a 150% gain in TAP and I don’t want to pay a massive tax bill if I sell it. Let’s hold off for now. Besides, the stock has gone nowhere but up over the last 5 years, it’s an American staple, and people will always drink beer; what if it goes up another 50%?”
A valid inquiry, but as investment advisors, what it really (hard) boils down to is the amount of risk one is taking in allocating such a large piece of their nest egg to one stock. “What if TAP’s price goes down 50%? How would that affect your ability to retire when you want? To live comfortably in retirement? To meet your investment goals?”.
We’ve all heard the painful stories of employees at companies such as Enron and National City who put their life-savings into their employer’s stock only to see it evaporate in a blink of an eye. And they’re not alone. Multi-billion-dollar hedge fund managers have also ended up with egg on their face as in taking huge bets on companies like Valeant Pharmaceuticals (NYSE: VRX) whose stock price went from over $250 to $25 in less than a year, a 90% loss of value.
In cracking open the concept of risk within a portfolio of stocks, we can break it down into two buckets:
· Market Risk – This is risk or volatility (the degree of ups and downs) related to the overall stock market and cannot be diversified away, except through investing in other asset classes like bonds.
· Company Specific Risk – This is risk related to a specific company and its stock. The Equifax (NYSE: EFX) hack in 2015 is a prime example of company-specific risk, which ultimately led to the stock dropping 38% in one week while the broad market was relatively unchanged. Company-specific risk can be diversified away by reducing concentrations to single stocks.
Hopefully by now, you get the idea that concentrations have the potential to poach away your retirement security in an instant. Which eggs the question: How does one address the issue of facing sizable tax bills in reducing them? There are several options to consider:
· A Simple Adjustment to Mental Framing: Consider this. Assuming a 15% tax rate, selling a concentrated position at a zero-cost basis would require earning an incremental return of just 1.6% annually over a 10-year period to offset the initial tax cost. This is a small price to pay for the benefits of diversification – reducing company-specific risk, especially if you are in any way reliant on the principal to meet spending needs.
· Selling in 3-5 Year Stages: Many clients don’t want to realize a significant amount of capital gains in any one year. Selling a concentration in relatively equal installments over the course of 3 to 5 years may keep the concentration risk around for longer, but will likely generate a smoother annual tax bill over that time period.
· Gifting Highly Appreciated Stock: If you are already making charitable donations or gifts to family/friends, consider gifting stock out of your concentrated position rather than after-tax cash. You will likely get a tax deduction for the market value of the stock donated and the charitable organization will be able to sell the stock immediately with no tax consequence to them. In terms of gifting appreciated stock, your children and/or grandchildren may currently be in lower tax brackets than yourself and may generate a lower tax bill in selling the shares.
To sum it up, concentrations can be an underestimated risk to an investor’s portfolio regardless of the asset. While no one gets egg-static over paying taxes, we ask you to consider the underappreciated benefits of reducing your concentrations and diversifying your wealth.
If you’d like to discuss the various options with us in more detail, don’t hesitate to give us a call or schedule an appointment.