“Never concentrate your investments in a single company, especially the company you work for.” – Jane Bryant Quinn.

In a previous post, I talked about how investors’ familiarity with local companies can lead to concentrated positions. When an individual stock crashes and burns, the results can be devastating.

Employer Stock

Whether it happens quickly or slowly, it really hurts if you have a concentrated position in your employer’s stock, and the stock tanks. Think about the unfortunate individuals who worked for and, had a good chunk of their net worth, invested in companies that went out of business. They not only lost their jobs but suffered catastrophic losses to their portfolios. Their financial future is not at all what they were counting on.

Diversification Is the Answer

The obvious answer is to diversify, to own many stocks, so the underperformance of a single stock, or its disappearance, will have little effect on your long term results. You want to make sure that your financial future does not get derailed by events at a handful of firms. Proper diversification includes different asset classes: Large Cap Stocks, Small Cap Stocks, International Stocks, Real Estate Investment Trusts, Bonds, Money Market Funds, etc.

If you have a properly diversified portfolio, you will capture the rewards that markets have to offer. With a diversified portfolio, you are, in effect, investing in the economy, and you can reasonably expect to get a return on your investment. Short term fluctuations will not be as worrisome, because over the long term you will benefit from the dynamism and growth of the overall economy. But this is not so with any individual company’s stock. Too much can go wrong, and its stock price may not recover from a sharp decline.

Client Reluctance to Heed Sound Advice

Financial advisors deal with this issue all the time. It’s one of the most difficult to convince clients of. As mentioned before, people are familiar with their employer, they may have been with the company for a long time, and perhaps they feel a certain loyalty to it.

They know logically that you should not put all our eggs in one basket. They are just convinced that it could not happen to them. But of course, no one ever imagines that it could happen to them.

Client Reluctance to Pay Taxes

To diversify, you must sell some (or all) of that favorite stock. You may be reluctant to sell, because you do not want to pay a capital gains tax. But keep in mind that it is currently only 15% for long term gains. (This may increase in the future.) And with prices down from the highs of last year, now would be a good time to talk to your financial advisor about selling that concentrated position and investing the after-tax proceeds in a diverisfied portfolio.

Potential Underperformance

The value of your stock could easily underperform the market by 15%. In Why It’s Wrong to Hold Too Much of One Stock, Jilian Mincer reported a study finding “a third of the stocks in the (S&P 500) index underperformed the overall market by at least 15% or more at any given year.”

Moreover, in 2006, when the S&P 500 increased by 15.8%, there were 6 stocks that declined by greater than 15% in only 5 business days:

Source: Bloomberg, Fact Set

Conclusion

Sharp declines and long term underperformance have happened so many times in the past. Why take the chance that it will happen to you?

“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…