It’s always great to have an investment that is a shinning star, but it’s possible for that star to explode. Investors sometimes find themselves with a concentrated stock in their portfolio, and may not understand the implications of holding such a position. In general a concentrated position is one that represents more than 10 percent of your portfolio.
There are several ways that an investor can accumulate a concentrated position. Employees of companies are prone to accumulate concentrated positions because of things like equity compensation, stock plan purchase arrangements, and buying
additional shares based on the belief in the company over the long run. Two other scenarios leading to concentrated positions are inheritances and price appreciations.
The reason why this is an issue is because the stock market can be a fickle thing, and anytime you invest you expose yourself to various types of risks like: market risk, liquidity risk, reinvestment risk, exchange rate risk, and business risk. Having a concentrated position gives an investor less flexibility in managing the risk for that security. The success of the individual position will be based largely on how the company associated with it does, and history is full of examples of this going bad at the investors expense.
A prominent example of investors losing big due to concentrated positions is Enron. Investors lost hundreds of thousands of dollars, and in some cases millions as the sentiment toward Enron, and also the company stock value declined. A more recent example is that of Lumber Liquidators, whose stock price began to decline after
the 60 Minutes story said that their laminate flooring made in China, had high levels of Formaldehyde, which is known to cause cancer. So far the stock price of Lumber Liquidators has declined over 40% this month from where it closed at the end of February around $52 per share.
Reasons People Delay Selling a Concentrated Position
Tax implications- due to capital gains.
Future price considerations- thinking the stock will continue to rise or rebound if on the decline.
Emotions- some investors have ties to companies that make them want to hold on to a particular stock.
I recently read an interesting article that implied millennials were afraid of investing. The article further stated that 51% of millennials had not held a conversation related to handling their finances with even one person. With the assortment of resources available to educate an individual about investing it’s shocking that over half of the millennial generation may not be taking advantage of these conversations. Most brokers offer free planning conversations. Also banks and credit unions would love to talk to their customers about planning, and increasing their long term assets. Furthermore, just about everyone knows someone who has experience with investing that they could talk to.
The article then detailed another shocking statistic from a 2014 Bankrate.com study stating that 39% of respondents aged 18 to 29 say cash is their preferred way to invest money that they don’t need for at least 10 years. Being one of the major asset categories cash definitely does play a part in one’s portfolio. Cash is great if money is needed in the short run; say within the next two years because you do not have to worry about fluctuations. However, given a 10 year timeframe that money would be better off being invested in other assets besides cash because of inflation risk.
More on Inflation Risk
Inflation is an increase in the cost of goods or services, so a dollar today will not buy the same amount of stuff at some point in the future. The lack of ability to buy the same goods with said dollar is also called a reduction of purchasing power. Economies need a certain amount of inflation in order to grow, so if your cash earns less than the inflationary amount you are in trouble. Currently rates for CDs and Money Market accounts are less than 2%, unless you are locking your money in for longer periods of time. The great thing about investing in stocks is that for the risk you take on you receive a rate that is typically higher than inflation which allows your money to grow over the long run.
Emily Pachuta, head of Investor Insights for UBS Wealth Management, said in a release. "Millennials seem to be permanently scarred by the 2008 financial crisis," and that “they have a Depression-era mindset largely because they experienced market volatility and job security issues very early in their careers, or watched their parents experience them, and it has had a significant impact on their attitudes and behaviors." That change in attitude has led to an increased preference for cash with an average of 52 percent of millennials portfolios being in cash, compared to 23 percent for investors of other generations. Investors who are risk averse think that it’s a smarter bet to be in cash, not realizing that they have already lost money due to the inflation risk which cannot be avoided. In the long term, inflation erodes a portfolio’s purchasing power significantly. At an average inflation rate of 3% per year, the value of a portfolio is cut in half every 23 years or so.
The Cost of Being Out of the Market
Below is a graph that shows just how much money an investor could lose by being out of the market on the best days over a given timeframe.