Concentrated Stock Holdings and Importance of Asset Allocation
by Justin Eccleston
Concentrated stock holdings can be hazardous to your wealth. Clients who own concentrated stocks do so for a variety of reasons. Typically, those reasons better explain how they came to own concentrated stocks than to explain why they should continue to own them.
The chart below illustrates over the last 15 years, there are 314 S&P 500 components that remain today. Of the original 500 companies, only 28 stocks, about 5.6%, provided a higher annualized risk-adjusted return during that time period (the darker blue dots).
Diversification from concentrated stock, particularly when it involves capital gains, can be a bitter pill to swallow. There is a much higher probability that a well-diversified portfolio will provide a greater combination of risk and return over long period of time.
Investment outcomes are largely determined by the long-term mixture of assets in a portfolio. With asset allocation becoming a household word, its importance is easy to overlook. Investors often spend a disproportionate amount of time on security selection or timing the market., This is often with the goal of increasing returns and/or reducing market risk. If an investor looked at their portfolio like a house, they would be focusing more on the décor than the foundation.
The chart below shows that most portfolio movements over time are explained by the long-term strategic asset allocation. Security selection and market timing are far less important for a diversified portfolio.
There is always going to be an investment opportunity that seems better, or a risk in the marketplace that seems more threatening. This may tempt an investor to change their portfolio, but if about 90% of their portfolio’s risk and return is explained by the asset allocation, why spend so much time worrying about the other 10%?