The Concentration Trap

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The Concentration Trap
by Bryan Olson, CFA, Vice President, Head of Portfolio Consulting, Charles Schwab & Co., Inc.
April 26, 2007

Reprinted from the April 2007 issue of Schwab Investing Insights®, a monthly publication for Schwab clients.

When I think of the dangers of concentrated stock positions, I'm reminded of a San Francisco–area Schwab client I met in March of 2000. Two years earlier, he had heard from friends about an upstart, industry-changing company in Internet search technology called Inktomi. Entranced by its potential, he bought 10,000 shares at $9 for a total investment of $90,000. The stock split twice in the next year, giving him 40,000 shares. When we met, an Inktomi share had risen to $231.62, making his investment worth $9.2 million. Though his Schwab consultant encouraged him to diversify his concentrated position, he was hesitant to sell for three reasons: The stock might go higher, he thought Inktomi was a safe company that would be around for years, and he didn't want to pay taxes on a big gain.

You can guess what happened next: Google entered the fray, the market for Internet search technology got fiercely competitive, Inktomi's share price started to drop—and the client still wouldn't sell. In December 2002, the company was finally bought by Yahoo! for $1.65 a share, shrinking his holding to a mere $66,000—$24,000 less than his initial investment, and a far cry from $9.2 million!

This investor's tale of woe may sound all too familiar for high-tech companies in the early 2000s, but the risk of plummeting share prices—and even bankruptcy—is not limited to any one sector. Consider this list of fallen angels, one-time industry leaders who fell into bankruptcy: Enron, Delta, Northwest, United Airlines, Polaroid, Delphi, Conseco and Owens Corning. Investors who deemed these companies "safe" for the long term and built up large positions in them were severely punished.

Worse yet, many investors are still dangerously exposed, often unwittingly, to overconcentrations. A recent review of over 2 million self-guided clients at Schwab found that nearly one-third of them had a concentrated stock position making up more than 20% of their portfolio.¹ If you fit this profile, here are some risks you may be exposed to unknowingly.

What is a concentrated position?
A concentrated position means that a stock, industry or sector makes up a disproportionate share of your total portfolio. Such concentrations may be a result of individual stocks and/or holdings within mutual funds or within separately managed accounts. Many times, one investment creates various levels of concentration—meaning that holding too much of one stock can lead not only to stock, but also to industry, sector and asset-class concentrations.

When you evaluate your portfolio and find a stock that makes up more than 10% of your portfolio, watch it carefully. If it exceeds 20%, we recommend that you take action to reduce the position. Other investment pros heed this advice as well: Private defined benefit pension plans have a regulatory limit of 10% in their own company stock, and many foundations and endowments monitor their individual positions each month to avoid taking on concentration risk.

Why are concentrations so risky?
Regardless of how it came about, a concentrated position can have a dramatically negative impact on the long-term wealth-creating ability of a portfolio. The risk comes from the extreme reliance a portfolio has on one position. If the stock does poorly, it can pull the portfolio down. Consider the risks to any one company and its product line: mismanagement, product obsolescence, fraud, new competitors entering the market and more. The key to any diversification strategy is to try to reduce this company-specific (or unsystematic) risk, which the market does not compensate you for taking.

Another way to illustrate the risk of a stock concentration is by looking at the number of S&P 500® index companies showing losses in years when the market performed well (see the darkest shaded boxes in the table below, "Some Stocks Drop Even as the Index Rises"). In 2006, when the index rose nearly 16%, nearly a quarter of its stocks had negative performance. And in 1999, despite the index posting a 21% gain, over half of its constituents showed a loss. The lesson here: If you held enough stocks, you might not be too worried about owning those stocks that fell in any one year. Sufficient diversification is the tool that helps contain and control the downside risk shown below.

Some Stocks Drop Even as the Index Rises
Year	S&P 500 index return	Stocks down (percent)	Stocks down (number)
2006	15.8%	24%	120
2005	4.9%	43%	213
2004	10.9%	24%	120
2003	28.7%	8%	41
2002	–22.1%	74%	368
2001	–11.9%	57%	285
2000	–9.1%	44%	220
1999	21.0%	51%	256
Source: Standard & Poor's. Returns have dividends reinvested.

How are concentrated positions created?
There are many ways an investor may end up with a concentrated position in his or her portfolio—from employer stock acquired through stock grants or a stock purchase program to inheritance or gifts. Other concentrations result from simple outperformance. Still others stem from purposeful buying of an industry or sector based on unique knowledge or interest level. Then there are the emotional attachments investors develop to their positions, and the aversion to paying taxes that makes those positions so seemingly difficult to unwind.

A particularly dangerous and common concentration scenario develops when employees are compensated with their employer's stock through several different vehicles: their profit-sharing plan, stock purchase plan and even their 401(k) plan. As much as you believe in and work hard for your employer, don't let loyalty blind you to the risk inherent in any individual company. When you own your employer's stock, you tie up not only your long-term finances with the company, but also your short-term finances—in the form of your paycheck and benefits like insurance that can be lost in cases of financial distress. Imagine a worst-case scenario in which your company not only loses market value, but also cuts back on jobs.

Concentration risk also rears its ugly head in the form of industry and sector concentrations. These can be nearly as risky but less obvious than pure stock concentrations, as they tend to result from a combination of different stocks and mutual funds. Here's why this kind of piling up can hurt you: Companies within a particular industry or sector often react in a similar way to news and events. So, for example, if a technological innovation made all semiconductor companies obsolete tomorrow, the investor who would sleep most soundly would be the one diversified across industries and sectors.

Even seemingly safe sectors can have extremely bad years. Utility stocks dropped 30% in 2001. And consumer staples fell 15% in 1999 (during the height of the tech boom). An investor concentrated in one of these sectors would have experienced amplified pain. Industry concentrations can have the same effect. Notice in the chart "Within Sectors, Industry Returns Can Vary" that even sectors with positive returns in 2006 had industries within them that experienced negative returns. Consumer discretionary stocks were up 17% overall, but contained the educational services industry, which was actually down 36%. An investor concentrated in that industry had a very different outcome than someone diversified within the sector.

Chart: Within Sectors, Industry Returns Can Vary

What you can do
For most situations, the first step is analyzing your portfolio and determining the percentage in each company, industry and sector. Clients can log in to schwab.com/portfoliocheckup to do this. If you have more than 20% of your portfolio in any stock, that's a serious warning. If you have more than 20 percentage points above or below market weight in a sector, consider that a warning light, too.

For illustrative purposes only.

For concentrated positions, the next step is creating a plan for reducing the concentration and thereby the risk. There are many avenues to tackle this problem. Consider gifting shares, selling outright or planning to unwind over time. You may notice that fixing one stock concentration will often correct industry, sector and asset-class overweights as well. For large dollar amounts or complex situations with restrictions on selling certain securities, talk with your Schwab consultant about how to use tax-free exchanges and other strategies to unravel or hedge that concentrated position.

And don't be afraid of taxes. We often see clients taking IRA withdrawals or investing heavily in fixed income securities to generate income that's then taxed at ordinary income rates (up to 35%) rather than selling a portion of a concentrated position and paying the lower long-term capital gains tax. If they had sold, they would not only have reduced a dangerous risk in their portfolio, but also lowered their overall tax burden at the same time. Similarly, you may find that it's much better to pay tax on an appreciated stock holding than to watch it lose its value and damage your long-term investing plan. As we often say: Don't let the tax tail wag the investment dog!

Although the potential reward of shooting for the moon with one near-and-dear stock may seem tempting, the risks should far outweigh the temptation. We often hear amazing stories of those who made fortunes on individual companies, but we rarely hear about the far larger number who paid the price of a high-risk strategy with big losses and sacrificed retirement goals.

Important Disclosures

1. Data from 2,231,937 Schwab client portfolios as of February 28, 2007, excluding those in Schwab Private Client™.

The S&P 500 index is an index of widely traded stocks. Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly.

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. Any references to particular securities, sectors and investment strategies are illustrative examples only and not intended to suggest pursuing a specific investment strategy.

Past results are not indicative of future performance.

While an investment in a specific sector may involve a greater degree of risk than an investment with greater diversification, strategies that include broadly diversified portfolios do not assure a profit and do not protect against losses.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

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