Planning Perspectives

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Five Strategies to Address Concentrated Equity

February 24, 2017 Investing Well, Investment Strategy

Owning too much of a single security can be hazardous to your wealth.

The risk involved in owning too much (usually defined as 30% or more) of one stock, what’s known as concentrated equity, is pretty apparent – too many eggs in one basket. What’s trickier is why some investors have such difficulty remedying a situation that can pose a real threat to their long-term financial security.

Concentrated equity can arise in many ways. Investors sometimes inherit large amounts of a single stock. They may have sold their business to a publicly traded company in return for substantial amounts of stock, or accumulated a sizeable position through stock and option incentives from a current or previous employer. In some cases, they’ve become enamoured with a specific company and acquired an overly large stake. Whatever the particular case, concentrated equity can become an issue investors know they should address but often ignore. Why? Primarily, it’s because of the enemy between our ears – all the emotions that money generates usually revolve around how the concentrated equity occurred in the first place.

The Psychological Barriers to Diversification
For example, let’s say you inherited a large amount of a single stock. While that’s nice, you may also have inherited an emotional attachment to the stock. Grandpa may have left you the reward he received from selling the company he built over a lifetime. Perhaps the stock was in the family for many years and has appreciated significantly. That can lead to what’s called “anchoring” – believing the future will be like the past. But, as the fine print says, “Past performance is no guarantee of future results.” Investors who cashed out after working at a company for many years may believe they understand the business very well and will recognize when it’s time to sell part or all of their substantial position. Slimming down a big holding might mean tax liabilities, or a reduction in dividend income. In other words, rationalizations abound.

In these instances, what’s really at work is fear of regret. Behavioural finance experts say that fear of doing something we might regret is stronger than the satisfaction of doing something profitable. Overconfidence is often a factor – many of us trust ourselves, and for good reason. But in the investing world, that could lead to overweighting a stock we believe has upside potential, while discounting the potential downside. Investors may double-down on a particular security that could throw their asset allocation out of whack and possibly add more risk and volatility. Tax aversion sometimes leads investors to take outsized risks rather than diversify sensibly. Plain old inertia plays a role too. When something has worked – “XYZ has been very good to me” – it’s easy to do nothing.

Strategies to Reduce Concentrated Equity Risk
No matter what the cause, it’s wise to take a step back and acknowledge that successful investing requires elevating reason over emotion Although every individual’s situation is different, if you have concentrated equity, there are a number of ways to reduce your risk. Here are some strategies to discuss with your advisor:

Bottom line? If you have concentrated equity and really want to avoid regrets, talk to your advisor about a personalized diversification strategy.