How Success Breeds Greater Risk in an Investment Portfolio

Life as a high-flying publicly traded company tends to be fleeting, and rarer than you might expect.

While the entire stock market has a history of generating positive returns, things get scrappier at the individual stock level, a JPMorgan analysis shows. Since 1980, roughly 40 percent of Russell 3000 Index stocks (we’ll call it the broad market) experienced catastrophic loss, or a decline of 70 percent or more from which the company never recovered. The cumulative return on the median stock since its inception relative to the broader market was an eye-opening, negative 54 percent. Two-thirds of all stocks underperformed the broader market, and over the past four decades 320 companies have disappeared from the S&P 500 and were replaced. More broadly, 65 percent of businesses fail in the U.S. within 10 years, according the U.S. Bureau of Labor Statistics.

The U.S. economy is a constantly evolving system that thrives on innovative destruction and renewal. No companies are immune from obsolescence, cyber threats, government overreach or instability, outright fraud, poor management decisions, theft of intellectual property or a host of other competitive, systemic threats. Even the best-managed companies can be destroyed by exogenous factors or black swan events that are beyond anyone’s control or ability to forecast.

No, we aren’t telling you all of this to excite fears and worries about the market. Rather, data simply underscore why it’s worth avoiding unnecessary concentration risk today, even if it runs counter to a “let your winners ride” impulse or you’re concerned about capital gains taxes. If your investment horizon stretches well beyond 5 years, managing concentration risks through disciplined portfolio diversification tends to yield better absolute and consistent performance.

GETTING CROWDED NEAR THE TOP  

After a long bull market, steady-handed stock-pickers may now have portfolios heavily weighted in a few very successful stocks. A single stock, or a handful stocks, that once represented 2 percent of a portfolio 10 years ago could potentially balloon to 10 percent or more if left untouched. While that’s growth all investors seek, it’s also significantly stepped-up concentration risk in a portfolio. Going forward, performance of that single stock, or group of stocks, will have an outsize impact on returns.  

There are other paths to concentration risk. Some investors hold an outsize proportion of company-issued stock in their retirement portfolios. Inherited positions are another common source of outsized positions. Some investors, by design, concentrate their portfolios in a handful of stocks rather than diversifying across sectors and assets. No doubt, fame and fortunes have been made by top stock pickers through history. Stan Druckenmiller, a Wall Street legend known for taking huge, concentrated bets once said, “The first thing I heard when I got in the business — not from my mentor — was, 'Bulls make money, bears make money, and pigs get slaughtered.' I'm here to tell you I was a pig.”

But we’re not all Stan Druckenmiller, and human hindsight bias tends to gloss over the thousands of other big-bet investors that lost it all for the handful of legends that rose to the top.

“Our clients come to us during or after long periods of wealth accumulation and it’s our job to manage that wealth in a manner that delivers long-term growth without the risk of permanent loss of capital,” says Matt Stucky, senior portfolio manager at Northwestern Mutual. “Avoiding excessive concentration risk by adequately diversifying is essential to delivering that promise.”

REDUCING CHANCES OF THE BIG MISTAKE

But let’s be honest, it’s difficult to sell investments that have handily outperformed. Five and ten-bagger returns can lull investors into leaving “well enough alone” because it’s easy to “love” a stock that’s done so well. Capital gains taxes are also a top impediment to trimming winners, as there’s no tax instance if you don’t sell. But consider two things.

First, in addition to growth, successful long-term investing that leads to financial security hinges on minimizing “the big mistake”, which essentially means limiting exposure to glaring risks. Concentration risk is one of those known, glaring risks. While it’s impossible to know how a stock will do over 5 or 10 years, if it represents 15 percent of your entire portfolio, it will drive performance going forward. While things could continue going well, remember, any given stock only has a 36 percent chance of outperforming the broader market over the long term. It is difficult for companies to deliver outsize growth and value creation in the first place, and even harder to sustain it as time goes on.

We’re not all Stan Druckenmiller, and human hindsight bias tends to gloss over the thousands of other big-bet investors that lost it all for the handful of legends that rose to the top.

Secondly, there’s an old saying: Don’t let the tax tail wag the dog. In most cases, taxes shouldn’t be the sole driver of an investment strategy. That’s true when it comes to trimming positions for the sake of diversification and concentration risk reduction. The data support this if your holding period is six years or more.

“Taxes are an important part of financial planning, but they shouldn’t be the only consideration. We constantly see tax minimization being improperly put in front of sound investment management,” says Stucky. “That being said, there are some rare circumstances where it doesn’t make sense to diversify a concentrated position.  If a concentrated position is likely to receive a stepped-up basis in the near future it can make a lot of sense to hold off on diversifying.”

Digging more into the tax debate, let’s say you trim a large position and take the maximum long-term capital gains tax of 23.4 percent. You then funnel the proceeds into a broad Russell 3000 Index fund. Recall, there’s a 36 percent chance that a single stock will outperform the Russell 3000 over the long term. If that stock outperforms, the decision to sell wasn’t optimal. However, if that stock underperforms the index (there’s 64 percent chance it will) the decision to trim was the better choice, even with the tax hit. However, if that stock underperforms the index (there’s 64 percent chance it will) the decision to trim may have been the better choice, even with the tax hit.

Diversification is insurance against an unpredictable future. And, if you’re still on the fence, think about it this way: Even the owners of extraordinarily successful companies sell stock to fund lifestyle pursuits, new investments or simply manage risk in their own long-term investment portfolios. Jeff Bezos, founder of Amazon, has sold $27 billion worth of company stock since it went public in 1997, according to Forbes.

PLANNING IN AN UNPREDICTABLE WORLD

An individual company’s odds of long-term, sustainable success are not tilted in favor of investors and CEOs. There are far too many competitive factors and exogenous threats that can upend a single company or entire sector. That’s why it’s important to build a comprehensive, strategic financial plan that diversifies wealth across individual positions, asset classes, and investment strategies. 

As we approach the end of the year, it’s a good time to reach out to your financial advisor (or begin working with one) if you have questions or concerns about concentration risk in your financial plan. A good strategy will not only address this risk, but account for a host of other risk factors that could hinder growth or make it more difficult to reach your financial goals.

The opinions expressed are those of Northwestern Mutual as of the date stated on this material and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any investment or security. Information and opinions are derived from proprietary and non-proprietary sources. All investments carry some level of risk including the potential loss of all money invested. No investment strategy can guarantee a profit or protect against a loss.