By Adrian Colarusso
June 1, 2022
In today’s choppy markets, there are few places to hide. Anything you do (or don’t do) comes with risk in some form or another.
Our clients bear the risk of concentration in a single stock.
How big is this risk, and why might it be a problem? It depends.
We look at investment portfolios with an “x-ray vision” (a risk model, not a crystal ball) that categorizes and quantifies the nature of the underlying risks. For example, a plain-vanilla S&P 500 ETF is just a collection of risk exposures that cause the index as a whole to go up or down.
The most important driver of the S&P 500 Index is simple, obvious, yet a bit grandiose – “stock market beta” – or, how willing are global investors to step out of less risky assets to buy stocks, and vice versa? This is a risk you are paid for over the long term.
There are other risks in the recipe, including a tiny amount of “single stock risk” (the risk that a single stock might go up or down for reasons completely unique to the company), but this risk is almost entirely mitigated by diversification.
Let’s say a former public company executive is sitting on $3 million in stock from her old company, and it represents the largest holding in her $4 million investment portfolio. The other million is in a plain-vanilla S&P 500 ETF (let’s ignore the fact that she should be even more diversified with that last million, but it’s better than a single stock). The company in this example is a well-established software provider.
Our risk model would estimate the volatility (standard deviation of returns, a measure of how ferociously its value moves up or down) of the S&P 500 index at around 16%. But this executive’s portfolio would exhibit a volatility of over 26%, about half of which is attributed to the unmanageable, uncontrollable risks inherent to her specific former company.
Who gets paid for bearing this extra risk? 1) The most influential executives whose efforts can swing results, 2) Exceptionally skilled stock pickers who are able to understand the value of the stock better than the market does (we are not those people) or 3) Insider traders (illegal!)
So, if you are locked into this concentrated position because of taxes, and not taking on this outsized risk because you have special knowledge or influence that you will be paid for it, what can you do?
Again, it depends, but let’s talk!
DISCLOSURE: Target Rock Wealth Management LLC is an Investment Advisor registered with the States of New York. All views, expressions, and opinions included in this communication are subject to change. This communication is not intended as an offer or solicitation to buy, hold or sell any financial instrument or investment advisory services. Any information provided has been obtained from sources considered reliable, but we do not guarantee the accuracy, or the completeness of, any description of securities, markets or developments mentioned.