For equity investors, the balance between risk and return manifests itself in a simple question: should I diversify my portfolio?
The answer depends on a number of factors, including your need or desire to grow your wealth quickly, your tolerance for risk, and your understanding of the consequences if things don’t go as planned.
Obviously, having a concentrated position in a single common stock can have great rewards.
Just look at the founder of Microsoft Corp. (ticker: MSFT) Bill Gates and Amazon.com (AMZN) founder Jeff Bezos. Gates ‘net worth is over $ 100 billion and Bezos’ is just under $ 140 billion. To put these numbers into perspective, their combined net worth is greater than New Zealand’s total gross domestic product. This wealth is the direct result of owning a large portion of the shares of the companies they founded.
The potential reward of holding a concentrated equity position must be weighed against the very real risk it imposes, especially for individual investors who are not the founders of successful listed startups.
Even for billionaire shareholders, large mergers can also be quite difficult on the balance sheet. In December 2018, Gates lost $ 1.2 billion of the value of his stake in Microsoft, and Bezos suffered a $ 21 billion drop in his holdings on Amazon. To put these numbers in perspective, they almost represent the value of Iceland’s entire GDP.
It could be argued, however, that since these guys are so wealthy, their risk of concentration is actually unimportant. They can lose $ 1 billion (or $ 10 billion) here and there without causing them any real pain. So the follow-up argument that one could make is that concentration risk is not really a bad thing.
This is a message that the author of “Rich Dad, Poor Dad”, Robert Kiyosaki, has been championing for decades. He says that in order to create great wealth, you should “focus … rather than practice diversification”. It may work well for people like Gates and Bezos, but for the average investor, it’s not good advice.
While it’s probably true that the losses suffered by the two billionaires in December may be of no consequence to them, the proportional losses suffered by a retiree with $ 1 or $ 2 million could have adverse effects on his financial well-being.
Between Gates and Bezos, the average drop during that month was 12.6%. The proportional loss for an investor of $ 2 million would be $ 252,400. That’s more than the median price of a home in the United States for someone using their investment portfolio for income, making up for that loss of over a quarter of a million dollars could take years. This means that the rules that apply to multi-billionaires really don’t apply to the average investor.
Here is an overview of some rules that apply to mere mortals:
- Create and live on a budget.
- Develop and stick to a plan.
- Align your portfolio with your plan.
- Look for hidden concentration risks.
Create and live on a realistic budget
Before you start thinking about putting all your eggs in one basket, think about the end use of that basket. If you’re like most Americans, you plan to use your retirement savings to fund just that: your retirement. To make sure you have enough savings to do this, figure out how much you are spending right now. Next, consider this amount in the context of living in retirement when you won’t have earned income to support your expenses.
Now it might seem obvious, but write it all down on paper (or a spreadsheet on a computer). If you have enough income to support your lifestyle and you have some extra cash left to spare, great. If you don’t, you need to rethink your spending habits. The reason is that they are not likely to change too much after you retire. In the long run, it is good practice to live a little below your means.
Develop and stick to a plan
Once you have a budget, build it into an overall financial plan that takes into account your current savings and investment pool. Have a professional advisor help you model this in the future to estimate its value at different times and under different what-if scenarios.
If these estimated results are not what you expected, modify your plan; spend less or save more. When the model takes you to a place that shows that your savings and investments will sufficiently fund your retirement, then commemorate it – and stick to it!
Align your portfolio with your budget and plan
As part of this process, ensure that the assets in your investment portfolio are properly aligned with your budget and financial plan. The composition of these assets will have a huge impact on your probable (expected) future rate of return. Different assets behave differently under different circumstances. And, each offers different expected rates of return and different types of risk. So the combination (or allocation) of these assets will play a big role in the success or failure of your budget and financial plan. Ask an advisor to help you develop your asset allocation to help you strike the delicate balance between risk and return.
Look for hidden concentration risks
Finally, look for the risk of concentration in places that may not seem obvious. Take a look at the mutual funds, exchange traded funds, and annuities you own. Make sure there is no potential risk of concentration in any of these vehicles. A fund that is overexposed to a particular stock or industry may impose excessive concentration risk on you. We frequently see investors with a large position in a popular equity, like Apple, in addition to funds that also hold large chunks of the same stock. Ask your advisor to provide you with an x-ray of the portfolio to determine where you might be vulnerable to concentration risk.
There is no doubt that Bill Gates and Jeff Bezos have made billions by holding a great concentration of a single title. But not all major stakeholders behave the same. Eddie Lampert, manager of hedge fund ESL Investments, has lost billions on his controlling stake in once-iconic retailer Sears. Robert Goldfarb, manager of the Sequoia Fund also lost billions due to a concentrated position of a losing investment. It was Valeant Pharmaceuticals.
While a focused position has its rewards, they don’t come without a healthy portion of risk.