Rethinking Diversification: A Nuanced Approach to Concentrated Stock Positions
Many of us become accidental single-stock investors through equity grants awarded to us by our employers. More than that, we often amass large positions that can make up a significant proportion of our net worth. Beyond raising questions about taxation, these positions raise the important but tough question of what to do with them.
When seeking guidance from professionals, the financial advice that is commonly given is clear: diversify. For individuals holding concentrated stock positions, the recommendation is to sell and reinvest the proceeds into broader investments, such as indexed mutual funds or ETFs. While financial advisors favor this approach because managing diversified assets is more aligned with their business models, they are also well-intentioned: Diversification reduces portfolio risk.
At DiversiFi, however, we believe that diversification deserves a more nuanced discussion. While reducing exposure to a single stock is sensible for many, the decision involves trade-offs that can significantly impact your financial goals and emotional well-being. Diversification is not one-size-fits-all—it’s a personalized calculus.
In this post, we break down the trade-offs of diversification as a strategy, how to evaluate the risks of concentrated stock positions and scenarios of when it is best to diversify or hold on to your stock.
The Trade-offs of Diversification
Diversification is not always the obvious or optimal choice.
It comes with trade-offs that should be carefully considered:
Potential Loss of Market-Beating Returns: Concentrated positions can lead to life-changing wealth if the stock outperforms the market. Reinvesting proceeds into broad-based index funds may limit your upside potential, effectively locking in average returns—a comparatively less exciting prospect.
Emotional Costs: Selling a position can trigger feelings of regret or FOMO (fear of missing out). Watching the stock soar after selling can be emotionally taxing and might undermine confidence in future investment decisions.
Tax Implications: Selling a large position rapidly can result in a significant tax liability, reducing the net benefit of diversification.
Evaluating the Risk of Concentrated Stock Positions
Assessing the risk of a concentrated stock position isn’t straightforward. Even financial experts often have opposing views on individual stocks. Rather than attempting to predict the stock’s trajectory, it can be more effective to evaluate risk through the lens of your personal financial goals and the potential impact of various outcomes.
For example:
What will diversification allow you to achieve? Will it help you pay for your dream house, fund your children’s education, or retire earlier?
How would these goals be impacted if the stock price rose or fell by 10%, 20%, or even 30%?
This approach shifts the focus from speculative stock analysis to pragmatic financial planning. It also frames diversification as a tool to manage personal risk rather than an abstract investment principle.
When Diversification Makes Sense
Securing Essential Goals: If your concentrated stock position already meets your essential financial goals, diversification may provide a safety net. For example, if a sharp decline in the stock price could jeopardize your ability to retire comfortably or fund other key objectives, selling a portion of your position to diversify makes sense. This strategy is grounded in marginal utility—the idea that securing your goals outweighs the potential for additional gains.
Reducing Dependency on Market-Beating Returns: If your life goals rely on extraordinary returns from your stock, caution is warranted. Broader market-based portfolios offer higher confidence in achieving goals like steady income and long-term growth, even if they lack the allure of outsized returns.
When to Hold On and What the Risks Are
Diversification isn’t always the best strategy. If you can comfortably meet your essential financial goals without selling your position, holding on to all or part of it might be a viable strategy.
Here are some examples of when holding on makes sense:
1. You’ve Already Secured Essential Financial Goals: If your financial needs—such as funding retirement, paying for a home, or supporting your children’s education—are already met, you may have the flexibility to hold onto the stock. In this case, the concentrated position becomes a calculated bet for additional upside rather than a necessity for financial security.
2. The Stock Has Performed Exceptionally Well: If the stock has consistently outperformed the market and continues to demonstrate strong fundamentals, holding onto a portion may allow you to capture future gains. However, it’s important to recognize that past performance does not guarantee future success.
3. You’re Comfortable Managing Risk: If you can tolerate the inherent risks of holding a concentrated position—such as significant price swings or potential losses—keeping the stock might make sense. This is especially true if the position doesn’t jeopardize your broader financial stability.
However, it’s crucial to recognize the risks:
No investment is guaranteed, particularly in individual stocks, even if you possess deep industry knowledge.
Where you hold on to a position, view it as a calculated bet—one that could—without guarantee—to lead to a significant windfall but isn’t essential to your financial security.
HAVE CONCENTRATED STOCK POSITIONS?
Do you have a concentrated stock position and are unsure whether you should hold it or diversify? Schedule a consultation with our advisors today to develop a personalized strategy that considers the nuances and is in line with your long-term goals. Contact us now to get started!
Final Thoughts
Diversification is a powerful tool, but it requires a personalized approach. By framing your investment decisions around your unique goals and financial situation, you can make more informed choices about when to diversify and when to hold your position. At DiversiFi, we aim to help you navigate this process thoughtfully, ensuring that your portfolio aligns with your aspirations and risk tolerance. Remember, diversification is not about forfeiting opportunity but about securing the life you envision.
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DiversiFi Capital LLC is a registered investment adviser located in CA and may only transact business or render personalized investment advice in those states and international jurisdictions where we are registered, notice filed, or where we qualify for an exemption or exclusion from registration requirements. Any communications with prospective clients residing in jurisdictions where DiversiFi Capital LLC is not registered or licensed shall be limited so as not to trigger registration or licensing requirements.
Past performance is not indicative of future returns, and investing always carries inherent risks, including the potential loss of principal capital. Any investment strategies are specific to individual clients and may not be representative of the experiences of all clients.
Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed.