Avoid Concentrated Stock Positions, Part 1

“Overconfidence is probably the most important of financial behavioral errors.” – William Bernstein.

Familiarity Leads to Concentration

A recent article, Why It’s Wrong to Hold Too Much of One Stock by Jilian Mincer, of The Wall Street Journal, explains that “individuals frequently overinvest in local companies.”

They think they’re reducing risk and optimizing gains by following the adage, ’Invest in that you know.’ Yet too much concentration in one stock actually increases risk as a lot of investors in Home Depot, Starbucks and Washington Mutual have discovered.

“It is a well-known phenomenon,” says Stuart Ritter, a financial adviser at T. Rowe Price Group Inc. in Baltimore, Md. “We think we know more about things that we’re familiar with.”

David Hirshleifer, a finance professor at the Paul Merage School of Business at the University of California, Irvine, says people have a natural tendency to like things with which they’re familiar.

“We treat things we’re used to as friends,” he says. As a result, investors buy local stock and donate to local charities. That same sense of familiarity also encourages people to invest too much in their own countries rather than to build an international portfolio.

Why is this a problem?

Conflict Between Concentration and Prudent Portfolio Management

When the stock market declines, we typically advise “stay the course.” Buy-and-hold is a sensible strategy for the long-term. But that applies to a well-diversified portfolio; it doesn’t apply to any single stock.

The reason is that a lot can go wrong with a single company, and it can happen very quickly. Any individual company or sector is subject to steep declines.

Weston J. Wellington of Dimensional Fund Advisors observes

“Recent events have provided an unusually harsh lesson of the importance of diversification. In a matter of days, shareholders of three financial giants—Fannie Mae, Freddie Mac, and Lehman Brothers Holdings—have seen their shares plunge into the penny-stock category. A fourth, American International Group, is scrambling for survival. “

Fannie Mae was once characterized by Money magazine as “America’s Safest Stock,” with a bulletproof business model that was “as close as you’ll get to an invincible earnings machine.”

Other “impregnable” companies include Pan Am (the premier airline of its day) Enron, “the smartest men in the room” Worldcom, etc. They went from brilliant to bust.

In the past, there have been many companies that once were considered powerhouses, but no longer are. For many years, General Motors was considered the bluest of the blue chip stocks. While GM has not gone out of business, having a concentrated position in its stock would have hurt your portfolio performance tremendously.

To be continued…