How to Eliminate the Dangers of Concentrated Stock Positions

Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.

There are many ways an investor can end up holding a large, concentrated stock position. There are also many reasons why an investor may be reluctant to diversify away from that position. But holding a large, concentrated stock position comes with significant risks.

Those risks include the likelihood that:

  • The concentrated position will be significantly more volatile than a broadly diversified portfolio;
  • The long-term return of the concentrated position will be lower than that of a broadly diversified portfolio; and
  • The concentrated position will suffer a greater decline in value (-50% or even a complete loss) than a broadly diversified portfolio.

Those risks are also associated with concentrated positions in a single industry, sector, or investment style. Broad diversification reduces or eliminates those risks.

Unless an investor has compelling reasons to maintain their concentrated position, they should liquidate that position and reinvest in a broadly diversified portfolio.

Two types of risk

When investing in securities there are two types of risk, “idiosyncratic” and “systemic.”

Idiosyncratic risk is associated with specific companies. For example, a firm may be subject to risks associated with regulatory changes, obsolete products, bad management decisions, weak financials, environmental disasters, fraud, or unforeseen events. These risks may cause a firm’s stock to decline in value even if the overall stock market is doing well.

Idiosyncratic risk can be diversified away. That is, as an investor adds more stocks to their portfolio, the company-specific risks become less significant. Eventually, if an investor adds enough stocks to the portfolio, those risks disappear. As a result, investors are not compensated for idiosyncratic risk.