Editors’ Note: This article mentions several individual securities in the course of discussing a broader subject. Please note that MarketMinder doesn’t make individual security recommendations. Any reference to them is solely incidental to the article’s discussion.
In my interactions with investors, I often find some who own a lot of a single stock—many even admit the holding is much more concentrated than they know is wise. Every now and then they think about selling it. Maybe some of it. Maybe all of it. But the decision very often runs aground when the investors consider when to diversify. Enter the endowment effect, or “ownership effect”—investors’ reluctance to part with a stock they already own. They find reasons to wait or defer for another day. But this is dangerous, and if you are doing this, owning up to how the ownership effect is skewing your thinking can help you refocus—and get better diversified.
In my experience, investors with concentrated positions tend to think in one of two ways, usually depending on how their large holding has done lately:
See the conundrum? Both paths lead to the investor kicking the can down the road. Both involve emotions—the fear of selling right before the stock skyrockets. That emotion is understandable, but it doesn’t make the action (or, rather, inaction) sensible. Holding onto a large position concentrates risk, and the conundrum above can become a never-ending cycle. What if the price you were waiting for never arrives? Or you could own something that is on a tear until it tumbles, when you can’t sell it so low—rinse, wash, repeat.
If you have a big holding you have been emotionally struggling to diversify, ask yourself the following: If, instead of a large holding of a single stock, you had the same amount in cash right now, would you buy “ABC” company with all of that cash? Or, alternatively, would you liquidate a diversified portfolio to buy only a huge, concentrated stake in “ABC”? I doubt it—and the logic applies in reverse.
A common rejoinder: “Yeah, but what if ‘ABC’ goes to the moon?” There are always examples of stocks booming fantastically here and there. But there are also always examples of firms busting. Anything can happen at any time, and there are plenty of examples of companies that didn’t turn out so well while the market as a whole trended positively. We have all heard the stories about companies like Enron, WorldCom and Tyco that failed dramatically in early 2000s scandals.
Here are a couple of less-extreme examples from the last bull market that didn’t need scandals to illustrate the benefits of selling a concentrated position: Transocean and IBM. Transocean is an Energy company—the world's largest offshore drilling contractor by revenue. On April 20, 2010, Transocean’s stock closed at $92 per share.[i] That day, news broke of an oil spill in the Gulf of Mexico, souring sentiment towards those potentially implicated. Shares plummeted. The stock rallied some through 2011 but didn’t regain that mark before 2014’s oil price crash decimated the sector. Over this span, Energy stocks overall lagged the world dramatically, rising 2.2% from April 20, 2010 to the bull market’s end on February 12, 2020 while world stocks rose 141.6%.[ii] Transocean? It shed -93.6% of its value over that span.[iii]
Or consider Technology giant IBM, a component in the flawed-but-well-known Dow Jones Industrial Average since 1979. There was no real cataclysmic moment for it, but in the 2009 – 2020 bull market, it returned 156.1%, less than half the MSCI World Index and about a fifth of the Tech sector’s return.[iv] Most of the time, stocks will behave like the sector they are in. But company-specific factors can matter—a lot.
It would have been easy for shareholders with large positions in either of these companies to fall prey to the ownership effect as they waited for their stock to rebound. Shrugging off such stories as though they can’t happen to you can be an expensive mistake.
If you are primarily looking for growth over a decent timeframe, diversifying stock holdings helps mitigate the risk of one big holding facing a specific risk that winds up crushing overall returns.
As an example, do me a quick favor. Use this calculator (after reading this in full, please!). Start with any amount in the “Present Value” field, leave the “Annual Additions” field blank, slide the interest rate button to 7% and enter 20 in the “Hypothetical Number of Years.” Then click “Calculate” at the bottom and see what the estimated future value is over the timeframe. As an example, $500,000 growing at 7% annualized for 20 years without adding any money results in an estimated future value of just below $2 million. Over 30 years, that becomes almost $4 million. Of course, calculators like this are purely hypothetical and run straight-line math. Markets don’t move in straight lines. But an assumed 7% annualized return for 20 years isn’t a pie-in-the-sky assumption—and, in dollar terms, that seems like pretty powerful growth to me, and with much less risk than staking your future on a single stock’s prospects.
So, do yourself a favor: Stop trying to forecast if your large concentration in a stock will keep going up or rebound from a recent low. Own up to the ownership effect—and diversify without delaying. Now, if tax considerations are holding you back, create a plan and write it down. Perhaps it makes sense to sell a bit each year along the way at regular, scheduled intervals a third party holds you to. Some of America’s smartest CEOs do exactly this via planned stock sales, and emulating that behavior seems pretty wise.
John Seibel is a Vice President of Client Service at Fisher Investments.
[i] Source: FactSet, as of 3/31/2022. Transocean share price at market close, 4/20/2010.
[ii] Ibid. MSCI World Energy sector and MSCI World Index returns with net dividends, 4/20/2010 – 2/12/2020.
[iii] Ibid. Transocean total return, 4/20/2010 – 2/12/2020.
[iv] Ibid. IBM total return, 3/9/2009 – 2/12/2020. MSCI World Index and MSCI World Technology sector returns with net dividends, 3/9/2009 – 2/12/2020.
If you would like to contact the editors responsible for this article, please click here.
*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.