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David Simpson, CFA, CFP®
Sr. Investment Strategist
Selling, gifting, hedging, exchange funds, and donations can help reduce concentrated risk in a diversified portfolio.
A well-diversified portfolio is key to a successful financial plan and depends on the starting place. If the portfolio is 100% cash and money market funds, implementing diversification in the portfolio is straightforward. Portfolios starting at a diversified point with many stocks may need to recognize some capital gains as part of the fine-tuning process. If a portfolio starts with a concentrated position, typically 10% – 20% or more, then the portfolio is at a much greater risk from an event in that single stock.
Concentrated positions can occur over time for various reasons:
There are benefits to a portfolio and net worth for concentrating a portfolio in a stock that has done very well, but the drawbacks are much more significant if the stock has not done well. Companies that were the better performers in previous years may no longer continue to perform well. General Electric had an eighty-year run as a top-10 constituent in the S&P 500 Index from 1930 to 2010. Cisco Systems is a key company that manufactures and sells key technology infrastructure components and was one of the stars of the late-1990s technology bubble but has since dropped off. The stocks of these companies have significantly trailed the S&P 500 total return from 01/01/2000 – 06/30/2024:
When considering the top-10 companies in the S&P 500 Index, they have seen returns exceeding that of the index overall. When considering future returns, it is important to look beyond the recent returns to examine the potential for continued returns now that these are the largest stocks in the index. It is important to remember that the stock price includes the expectations about the company’s future. Unfortunately, when looking at the data from 1927 to 2023, the annualized five-year outperformance was -0.9% after joining the top 10 of the index, while it was 20% for the five-year prior.
Since the concentrated position may hinder the portfolio’s future of the portfolio, diversification is an important step. There are multiple methods to help reduce the impact on the portfolio:
Visit our knowledge center for more information on concentrated stock positions and donor-advised funds, including how DAFs can help maximize giving impact and tax benefits and grow charitable giving.
While there is a need to diversify the portfolio, selling a concentrated position may come with capital gains taxes. If part of the position is sold, generating $1 million in capital gains taxes for example, the portfolio needs to overcome this to get back to where it was before. A $10 million portfolio would require a 10% return for one year or a 1.92% annualized return for five years to overcome the impact of the taxes. While this requires a return for the portfolio, this should be weighed against the potential for underperformance if the stock does not continue to see the same level of growth over the next five or ten years that it saw previously.
While there are many considerations, there is no single answer. None of the diversification methods are mutually exclusive. A well-built financial plan can use these methods together to help accomplish various goals. Spreading the diversification over several years can reduce the impact of taxes. The well-diversified target portfolio is the goal but will take a thoughtful approach to achieve it.
Your advisor can help determine how best to diversify your portfolio and which combination of methods may provide the most benefit. Not a Mercer Advisors client but interested in more information? Let’s talk.
Sources:
Rizova, Ph.D., Savina and Saito, Ph.D., Namiko. “Addressing Concentrated Stock Positions in Client Portfolios.” Dimensional Fund Advisors, June 2024.
“Large and In Charge? Giant Firms atop Market Is Nothing New.” Dimensional Fund Advisors, 17 June 2020.
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All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. Some of the research and ratings shown in this presentation come from third parties that are not affiliated with Mercer Advisors. The information is believed to be accurate but is not guaranteed or warranted by Mercer Advisors. Content, research, tools and stock or option symbols are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy or product made reference to directly or indirectly, will be profitable or equal to past performance levels. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. All investment strategies have the potential for profit or loss. Diversification and asset allocation do not ensure a profit or protect against a loss. Hypothetical examples are for illustration purposes only. Actual investor results will vary. For financial planning advice specific to your circumstances, talk to a qualified professional at Mercer Advisors.
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