Concentrated Holdings Have No Place in a Portfolio

This company paid huge bonuses to top producers, which were often in the form of company stock. Since the stock price surged over this time period, employees gleefully watched their net worth skyrocket, and many became multimillionaires well before their 30th birthday.

As the stock continued its meteoric rise, several employees saw no reason to sell any stock for two key reasons:

1. Management: The leaders of the firm urged employees to keep their entire 401K and other investment vehicles in as much company stock as they could own because the prospects of the firm were so bright. Employees were also hesitant to send any signal that they would ever doubt management's bullish tone.
2. Employees Had an Edge: Employees often prefer to own the stock of their employer because they believe that they have an "edge" over other investors, since they are closer to the day-to-day operations of the firm.    

Unfortunately, this company's name was Enron, and the chart below concludes this story of how billions in wealth disappeared in a matter of weeks, as the world learned that management had committed fraud.

Those who felt that they had an "edge" or listened to management's fairy tale walked away with an empty 401K and unemployed.

These victims should not be faulted for failing to recognize the fraudulent activity. Detecting fraud is incredibly difficult since so few culprits are involved. Rather, their mistake was putting way too many eggs into one basket, and they paid the price.

NOTE: Fraudulent activity is actually extremely rare. Enron and WorldCom stand out because of their size and impact to financial markets, but the number of cases where large, publicly traded firms are caught committing fraud is quite low.

Simply put, Enron is a great example of why investors must maintain strict diversification at all times. 

Concentrated Holdings Are Deadly 

Investors often accumulate a concentrated holding for a number of reasons. A CEO may take her company public and then have a large amount of stock that she cannot legally sell. An individual investor could have purchased Apple's stock at $3 a decade ago and never sold shares. The list goes on and on.

These positions typically develop over time, and it's safe to say that accumulating a concentrated holding is a great problem to have in a portfolio. However, as this position rises relative to the overall size of the portfolio, the risk quickly outweighs any potential for future gain.

In the example above, investors and employees were crushed by the fall of Enron not because of the fraud, but rather due to the overwhelmingly large allocation to one position. Let's look at other instances in recent history that don't involve illegal activity but further prove our point:

1. Competitive Threats: Decades ago Eastman Kodak dominated the print film industry, and the stock performance reflected their success. However, management was arrogant and lazy, which ill-prepared them to handle the competitive threat as digital cameras hit the market. They filed for bankruptcy last year.
2. Government Risk: Currently, the Obama administration is targeting the coal industry and could permanently change the domestic landscape for this fuel source. Coal stocks have been decimated since he won his second term in office.
3. Poor Execution: Knight Capital accidentally deployed test software code into production, which caused major disruption at the NYSE one fateful morning in August 2012. This seemingly tiny mistake ultimately took down one of the most respected trading firms on Wall Street in a single day, despite having a strong management team and a history of solid performance.

Each of these examples represent risks that can be mitigated through proper diversification and avoiding concentrated positions. Always remember that the goal of investing is to manage risk, not take risk, and keeping any one position higher than 20% of your investible assets is strongly discouraged.

Implications for Investors

Stocks get handed down through generations, some make investors very wealthy in a short amount of time, and others represent the company founder's life achievement. In each of these scenarios, emotional attachments understandably develop toward a stock in the form of loyalty, pride, and admiration.

However, mixing emotions into investing provides absolutely no upside to an investor, and any emotional link to a stock is guaranteed to be a one-way street. A concentrated holding could be in an investor's family for generations, but no loyalty will be returned to that family if a competitive threat were to make the firm's business model obsolete.

Admittedly there are instances when an investor is forced to maintain a concentrated position. For example, managers are often required to hold stock for a specific time period, while others fear that selling stock would lead outside investors to believe that future prospects for the firm are dire.

Fortunately, strategies exist for those who cannot sell but still want to mitigate the risk inherent in concentrated holdings. The Investment Committee strongly urges anyone holding a concentrated position to consult his or her financial advisor to begin the necessary steps to shield your portfolio.

The bottom line is that there is no excuse for exposing a portfolio to unnecessary risk, and concentrated holdings should be eliminated or hedged at all times.

This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion of our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Global Financial Private Capital is an SEC Registered Investment Adviser. All charts courtesy of BigCharts.com.