Fortune Doesn’t Always Favor the Bold: The Perils of Concentrated Stock Positions

Yet even the smartest, most determined fund picker can’t escape a host of nasty surprises. Next time you’re tempted to buy anything other than an index fund, remember this – and think again.

– Robert Barker, “It’s Tough to Find Fund Whizzes,”, December 17, 2001

Many successful entrepreneurs and executives who hold much of their wealth in a highly appreciated single stock (i.e., accepting uncompensated idiosyncratic risk) face a difficult financial dilemma: Sell the stock and diversify, having to pay the taxes owed, or risk catastrophic loss. Advisors can help by educating their clients on the historical evidence that demonstrates diversification is the prudent strategy.

Investors need to distinguish between two very different types of risk: good and bad risk. Good risk is the type that you are compensated for taking, with the compensation being in the form of a risk premium – greater expected (not guaranteed) returns. For example, equities are riskier than fixed-income investments. Therefore, equities must compensate investors by providing greater expected returns. The risk, of course, is that the expected does not occur. Similarly, the stocks of small-cap and value companies have been riskier than their large-cap and growth counterparts. And just as the risk of owning equities cannot be diversified away, the risk of owning small-cap and value stocks cannot be diversified away. Therefore, small and value stocks must also carry risk premiums.

In addition to the risk of equities and the risk of small and value stocks, there is another type of equity risk: the idiosyncratic risk of an individual company. Consider the case of Enron, once named by Fortune as “America’s Most Innovative Company” for six consecutive years. Its stock achieved a high of $90.75 per share in mid-2000 and then plummeted to less than $1 by the end of November 2001; it eventually declared bankruptcy. Since this type of risk can easily be diversified away, the ownership of individual stocks is one that the market does not compensate investors for taking. Thus, it is bad (uncompensated) risk. And because investing in individual stocks involves the taking of uncompensated risk, it is more akin to speculating than investing.