Investment

The challenge of a concentrated portfolio

May 2016

A share portfolio based on one company is common, but dangerous.

An emotional connection to your shares could be your biggest risk, writes Jane Olsen.

Many executives, over the course of their careers, amass a share portfolio focused on one company.

Often this comes from their remuneration package, sometimes from inheritance, or because they’ve been drawn to an initial public offering, deciding it was a good investment option.

In creating such a concentrated share investment, these executives often aren’t aware of the potential risks they may be exposed to.

”A concentrated holding in any single stock, whether in a private or publicly listed company, carries market, liquidity and concentration risks which should be managed.

And the closer retirement looms – the more critical it is to manage these risks. Share price failure of a key company the investor has a holding in could potentially devastate their wealth.

An obvious solution to an executive stuck in this position is to simply expand their stock investments into a broad, diversified portfolio. The problem, experts repeatedly say, is that for many people that simple step isn’t so simple. The way they’ve accumulated a large, concentrated holding in a single company means the investment may have been personal, even emotional.

  

According to ANZ Private senior investment specialist Pike Talbert, people generally end up with a concentrated position in one of two ways: by acquiring or earning shares in the company they work for as part of their compensation package or through inheritance.

This personal connection to their shares, he says, is why people often find it difficult to sell or reduce their position, even when they know it’s riskier having a chunk of their wealth in a concentrated holding compared with a diversified portfolio where risk is spread across a number of stocks and asset classes.

This situation becomes critical the closer you get to retirement.

Financial planner Peter Foley – principal of Thirdview FP and key contributor to the Portfolio Construction forum, a thought-leading institution focusing on investment-evolving strategy – says it’s important that those considering retirement carefully consider their goals, capital and income requirements, risk tolerance and the role of a concentrated stock portfolio in their overall investment strategy.

“They need to consider if holding shares they probably accumulated as part of an old employee share scheme will maximise the probability of them achieving their retirement goals and objectives.”

The solution: discard emotion

A parcel of shares in a quality company can form a solid foundation to build a robust portfolio, Foley says, but investors will typically need to sell down their position, which can be difficult for people who have an emotional attachment to their shares.

When talking to a client who is emotionally attached to an asset, be that shares, property or even art, Talbert encourages them to think objectively.

“I challenge them to look objectively at an asset’s valuation and growth potential relative to other investments, and imagine that it was given to them by an alien from Mars, not a grandparent or company they spent 20 years at,” he says, adding that the most successful investors are disciplined, unemotional and know when to sell.

“People always talk about the importance of buying at the right time but it’s equally as important to know when to sell out, which is a fundamental investment principle,” Talbert says.

“That principle is even truer when it comes to a concentrated portfolio.”

The easy way to lose half-a-million dollars

Pride Advice financial adviser Brett Schatto regularly encounters people with large, single-stock holdings either through an employee share scheme, IPO, inheritance or “hot tip”.

Schatto remembers an interesting meeting he had in early-2007 with a woman who had received a “hot tip” at a barbeque about uranium producer Energy Resources Australia.

In a few short years her fledgling investment in ERA had almost tripled to around $500,000 and the woman wanted some advice on what to do next.

Schatto explained the dangers of having a large chunk of wealth concentrated in a single stock and recommended she significantly reduce her exposure to ERA, using the profits to build a well-diversified portfolio, not only in terms of stocks but asset classes.

She rejected his professional advice and decided to hold onto her ERA shares. Schatto never heard from the woman again but subsequently watched the ERA share price plunge from a high of about $17 in mid-2009 to its early 2016 level of 35¢, valuing her investment at around $6000 today (assuming she continued holding onto her shares).

Weigh risk

“Having your wealth concentrated in a single company can be risky but it really depends on the situation, and furthermore people don’t usually become wealthy without taking on some risk,” Talbert says.

“Risk is very personal and subjective. If it’s a senior executive who intimately knows and believes in the company, and has a meaningful portfolio of other assets, including property and cash, it may be a smart and low-risk strategy. But for an older couple headed for retirement with only the family home and a single parcel of shares, it’s probably sensible to build a lower-risk, diversified portfolio.”

It is understanding how to manage this risk that becomes crucially important for someone with such a portfolio.

Foley says the rules differ for those heading for retirement and those focused on accumulating wealth because liquidity and income is critically important for the former.

“We’ve found that as people move into retirement, they don’t want their wealth tied up in a single stock or company,” he says.

Think Dick Smith Electronics.

Commentators agree that one of the best moves you can make is using a professional adviser who is objective and trained to consider a client’s financial needs, who will develop a robust, comprehensive financial strategy that maximises the probability of achieving your long-term goals.

Principles for dealing with a single-stock portfolio

  • Carefully analyse, with professional advice, the quality of the investment.
  • Focus on the risks of your overall investment, if the stock price falls, how will that affect your financial wellbeing?
  • Challenge yourself to focus on the performance of an investment, not your emotional connection to it.
  • Are your current share investments leading you to your eventual retirement goal?