One of the many things we do when a prospect comes to us is analyze their current portfolio. We do this so we can assess the current risks in their portfolio that they may not be aware of and identify ways to minimize those risks, thereby getting the overall portfolio working for them, in a way that is in line with their particular risk tolerance.
We see many issues when analyzing portfolios, including, but not limited to:
- asset allocation that is much riskier than their tolerance
- lack of multi-asset class benefits by using only one or two asset classes (e.g. 100% equities / no fixed income / no alternatives)
- heavy cash exposure – we often hear from people that they build up cash as they are hesitant to make a decision on how to invest it. Unfortunately, with cash returning about 0.001% these days it creates a huge drag on the portfolio.
- the use of securities with high expenses (e.g. variable annuities (typically over 3.5% in expenses) or front-load mutual funds (may charge 5% up-front))
- management fees that are higher than industry standards – we’ve seen people with significant size portfolios paying over 2% – that’s crazy!
We could do a blog on each one of these issues, but this week the focus will be on concentrated position risk.
So what is a concentrated position? It is a held position (typically equity) that makes up a substantial part (20% or more)
of an investor’s overall portfolio. A common example is a stock inherited from a grandparent. Another situation that we often see is a concentrated position risk stemming from a client’s company stock.
Some public companies offer many ways for the employee to get company stock. Here are just a few examples: restricted stock grants, ESOP programs, deferred comp programs, stock options, company stock within the company’s 401k plan, etc. Many people don’t realize how much these positions may have grown over time or, because of “bucket mentality”, they don’t even think of it as part of the overall portfolio. But they should.
In a recent meeting with a prospect, we identified that her company stock made up close to 30% of her overall portfolio. She wasn’t aware that her position was anywhere near this percentage until we pointed it out, but like many people she didn’t seem too concerned at first.
Here’s the problem: the major risk associated with such a portfolio is a lack of diversification; a concentrated position makes a large portion of the investor’s wealth dependent upon the performance of one particular stock. At DWM, we also call concentrated position risk ‘torpedo risk’, because that’s what a concentrated position can do to your whole portfolio, and hence your overall financial plan. It can hit and sink it just like a torpedo- not good. People tend to think this won’t happen to them, but so did the former employees of Worldcom and Enron.
Don’t let ‘torpedo risk’ from a concentrated position ruin your portfolio and/or financial future. A good rule of thumb is to keep all company-specific positions to less than 6% of your overall portfolio value, if possible.
Of course, there may be reasons for keeping a concentrated position such as restricted stock/options that follow vesting timelines, emotional attachment, low cost basis tax concerns, trading volume concerns, etc. An advisor like DWM can help you work through those issues via different strategies (e.g. dollar-cost averaging out, “collars” and other derivatives strategies, prepaid variable delivery forward contracts, exchange funds, etc.) and help you put together a portfolio that’s working for you, free of unnecessary risk and capable of meeting your long-term goals.