We’ve all heard it: your investments should be diversified. But what does that mean, and why is it so necessary as part of a stable financial plan?
If your investments are not diversified, you could also be over-concentrated in one or a few individual companies. Over-concentration of your investments typically means that too many of your holdings are tied to a single investment. A concentrated stock holding creates a problem, because a large portion of your wealth is then dependent on the success of one stock or one company.
Here are some of the other risks of owning over-concentrated stock, and several factors you should take into consideration when investing.
How Over-Concentration In Individual Stock Can Happen
Often, over-concentration becomes a problem for people who hold individual stock positions. People could receive a large amount of stock from family members, significantly invest in their own company -- due to how companies pay out bonuses, offer employee stock option plans, or provide incentives -- or buy stock in a company they used to work for.
However, considering that two-thirds of stocks underperform the market, it is likely that a concentrated stock position will underperform over a long period of time.This should be reason enough to seek more diversification within your portfolio.
More importantly, if you own an individual stock, you have to be right twice: when you buy it and when you sell it. When you own an individual stock -- specifically something that becomes a large concentrated part of your portfolio -- there are a lot of extraneous factors that tend to surround that position, making it even more difficult to garner a positive outcome.
Emotion Can Dictate Decisions
There are two main problems with over-concentration in an individual stock position. The first is that there are a lot of emotions that typically surround investment decision-making -- and this becomes even more true with individual stock, since it usually is in a company close to your heart. This can cause people to be hesitant or make a biased decision regarding their investment.
Moreover, there are tax consequences. If you buy stock that represents a large amount of your portfolio and you decide to sell, you pay taxes on it. Tax implications can encourage people to hold on to a stock longer than they should.
Ultimately, owning an individual stock holding as a concentrated part of your portfolio is difficult to manage over a long period of time. Emotions and tax consequences could cloud your judgement, leading to a lower than expected ROI.
Life Factors Play A Part
Another risk factor of owning a concentrated stock position is age. For example, a 30-year-old working at a company may want to risk owning their own company stock. If the investment doesn't work out, their time horizon gives them the opportunity to make up the loss. However, if a 60-year-old approaching retirement has half or more of their portfolio invested where they work, and the company’s stock goes down 70%, they don’t have the time before retirement to make back the loss suffered.
This is especially harmful to those who have been at a company for a long period of time and are closer to retirement. If you lose your job suddenly, not only are you out of work, but a large portion of your net worth may have been lost. If you have retirement savings in your company stock and the company goes out of business, you can't put that money back into a 401(k).
You may also end up having restrictions upon liquidity if you work for the company, such as blackout periods once a quarter where you can't sell the stock. A negative earnings announcement or product failure could substantially impact the stock price and you may have to wait to sell the position when the blackout period ends. Certainly not the best situation.
Although there are a lot of risks with highly concentrated stock positions, there's nothing wrong with owning individual stocks; the issue starts when you concentrate 20% or more of your investable assets in one position. Some of the top risks of not being diversified and over-concentration are:
- The unlikeliness a position that will outperform the market over a long period of time.
- Single-stock ownership exposes you to higher volatility, lower liquidity and higher risk than owning a diversified portfolio.
- Your financial success could be tied to one company’s performance.
The general consensus among financial experts is that an adequately diversified portfolio should have no more than 10 to 20 percent of total investmentable assets in one stock. This helps you reduce risk and limit exposure to a poor investment.
RMR sets an investment exposure limit at 7-10%, minimizing risk while increasing diversification when it comes to an individual fund or security. To learn more about over-concentration of individual stock holdings, or to get help with your portfolio, contact RMR Wealth Builder