The Stock Concentration Trap

July 19, 2012

Investors can end up holding a disproportionate amount of a single company's stock in their portfolios for a number of reasons. Sometimes, people don't want to sell because they believe the price of the stock, however high, might go higher. They might believe the company is a "safe" investment and will be around for years. They might want to avoid paying taxes on the gain they would realize if they sold. Or they might not even realize they're overconcentrated: They could be employees who gradually accumulate company stock through profit-sharing, stock purchase plans, and even their 401(k) plans, and never bother to diversify.

Whatever the circumstances that lead to a concentrated position, it's a risky position to be in. Here, we'll discuss the risks of concentration, how to tell if you're in a concentrated position, and what you can do to reduce concentration risks in your portfolio.

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 concentration, but also to industry, sector and asset-class concentrations.

When a stock accounts for 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 sharply negative impact on a portfolio's long-term ability to create wealth. The risk comes from the extreme reliance a portfolio has on one position. If the stock does poorly, it can pull the whole 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. If you hold enough stocks, you might not worry as much about those stocks that may fall in price over any given time frame. Sufficient diversification helps manage downside risk. 

How are concentrated positions created?

Investors may end up with a concentrated position in their portfolios in many ways—from employer stock acquired through stock grants or a stock-purchase program to inheritance or gifts. Other concentrations result from outperformance. Still others stem from purposeful buying of an industry or sector based on specialized experience 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 comes 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 diversified investor would probably sleep more soundly than the one who invested exclusively in the semiconductor industry.

What can investors 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.

The next step is creating a plan for reducing any concentrated positions you identify. 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 ways to use tax-free exchanges and other strategies to unravel or hedge that concentrated position.