The risk of a concentrated portfolio

Consider taking steps to help manage the risk of a large position.

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In investing, as in life, it is possible to have too much of a good thing. In a portfolio, for instance, an inheritance, equity compensation, or just a great run in an investment could lead to more assets in a single investment than planned.

Why could putting too much of a portfolio in a single investment be a risk? As history reminds us, even long-admired blue chips can implode, sometimes abruptly, taking overly concentrated investors down with them.

“History is littered with examples of high-quality companies that ended up in serious trouble—remember the bankruptcies of Lehman Brothers and WorldCom,” says Joe Steeves, senior vice president, Wealth Advisor Solutions. “The point is that a company that may look great today could get in trouble down the road, and no one knows which one it will be, so it is important to think carefully about how to manage concentration in a portfolio.”

Fortunately, there are many strategies to do just that. The options range from selling some stock and diversifying to more complex strategies.

The downside of concentration

All investors face risk, of course. There’s “market risk,” where you take the chance that stocks in general might move down. But investors in individual stocks also face “idiosyncratic risk,” the unique challenges that could hurt the performance of a single stock. For example, a company’s outlook could suffer because of accounting scandals, CEO failures, or new competitors.

These idiosyncratic risks cause individual stocks to be much more volatile than a diversified portfolio. We looked back at the average volatility of individual stocks in the Russell 3000® Index from 1995 to 2015 and compared it with a hypothetical diversified portfolio—which we simulated by choosing 150 random stocks from the Russell 3000® Index 5,000 times and averaging the results.

The outcome? The average annualized volatility of a single stock was more than double that of an average hypothetical diversified portfolio (see chart above). Because each company faces individual risks, diversifying broadly across many different stocks can help to manage that risk.

“The challenge of a concentrated position is that it can increase the risk level of a portfolio,” says Ann Dowd, CFP®, and vice president at Fidelity. “The simplest solution may be to sell at least part of the position and invest in a more diverse portfolio. For investors who cannot or do not want to diversify, there are strategies to help manage risk and reduce taxes in the process. But they can be complex, so you may want to work with a financial adviser.”

Spotting concentrations

When does big become too big? With investments, the answer varies, both based on an individual investor’s situation and goals and the risk level of different investments. Here is one set of general guidelines that underlies Fidelity’s Planning & Guidance Center. You can use the Planning & Guidance Center (login required) to run an analysis of your portfolio.

A case to sell and diversify

Diversification does not guarantee a profit, but it can help to reduce risk. So, the first thing to consider is the risk that a concentrated position introduces to a portfolio. If the risk is uncomfortably large, selling down the position and diversifying can be the simplest solution—but consider taxes or restrictions before taking action.

“A broadly diversified portfolio can capture the growth potential of the market while reducing the particular risk of an individual stock or bond,” says Dowd. “A well-diversified approach through a mutual fund, exchange-traded fund (ETF), managed account, or portfolio of securities can provide balance between risk and return potential.”

The benefits of diversification are based on the idea of bringing together investments that are not perfectly correlated—meaning they don’t always move up and down together. This strategy is achieved by diversifying a portfolio among asset classes—stocks, bonds, and cash—and within each asset class, by spreading investments among companies from different industries, sectors, and geographies, and of varied sizes.

Options beyond diversification

For some investors, moving into a diversified strategy is not appealing or possible—whether because of the tax implications of a sale, because of a provision of ownership that prevents a sale, or because, despite the risk, they remain devoted to the company or investment. If that’s the situation, consider a more sophisticated risk management strategy.

These approaches may help manage taxes and sometimes even generate income from the sale of option contracts written against the stock position. But they may also come with significant tax and transaction costs, which you should weigh as you decide on an approach. Because of the complexities of these strategies, make sure you are working with a trusted adviser or other financial professional.

Staged selling. Sell a portion of a position each year over a set time period, say three or five years. This strategy may appeal if the goal is to diversify but the concentrated position has very high embedded capital gains and the tax bill from an immediate sale would be too large to handle in the short term. A gradual sell-down spreads taxable gains over several years, though you have to weigh the benefits of this strategy against the risk of retaining the position.

Options. Option strategies are not right for all investors; they involve risk and expense. But they may have the potential to reduce the risk of a concentrated position.

If your goal is to protect against downside risk without selling, consider purchasing put options. Puts can help to protect against the risk of losses in a stock while maintaining your opportunity to participate in any appreciation. A protective put strategy can be an expensive way to hedge downside risk, however—so be confident that any future gains from the underlying stock position will be enough to cover the cost of the options.

Alternatively, a covered call can generate immediate cash flow from the position. Covered calls limit upside potential—if the stock rises, the seller of the call may be forced to sell shares below market price—but covered calls also provide income, and the income reduces the overall risk level of the position. However, the income stream will not provide complete downside protection; so while this strategy provides a degree of risk reduction, it doesn’t protect against a large downturn.

If you want to hedge your position without incurring the cost of buying a put, a cashless collar may help. This strategy involves purchasing a put to protect from losses while selling a call option that limits your upside potential. The proceeds from selling the call generally offset the price of the put—hence the strategy’s name. However, remember that puts and calls have embedded commissions and fees, so the cashless collar isn’t entirely free of cost.

Securities lending. Loaning a portion of the concentrated stock holding to other investors who want to borrow the stock as part of a short sale may also reduce risk. The lender runs the risk that the borrower fails to return the securities or is delayed in doing so, but the lender will receive interest on the loan. This strategy involves giving up some liquidity, however, and it does not protect from downside risk beyond the income. Again, it is important to note that these strategies may require large minimums and are not available to everyone.

Making a decision that works

Each individual needs to weigh the pluses and minuses of these risk-mitigation strategies versus an outright sale. But the important thing is to act. Keep in mind that a concentrated position can pose a serious risk to your financial goals. Even the most established companies can run into trouble, and when they do, a diversified strategy or hedged approach to risk may look very attractive.

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Read Viewpoints®: "The pros' guide to diversification."