Concentration or diversification?
By Rob Wrubel, CFP®, AIF®
Here at Cascade Investment Group, we work with people from many different backgrounds. Families who have created wealth. Younger people in retirement plans starting to create assets. People close to retirement. Families with special needs members. Non-profit endowments. Business owners. We see a wide variety of people with different issues each week.
This year and last, I have met with a number of people who shared one investing trait – a significant portion of their investments were tied to one company. These situations fell into one of two categories. 1. Business owners with the vast majority of their net worth tied to the company they own and operate, or 2. People who have worked for the same company for many years and saved or were granted stock in the company. A third similar category comes up with people that invest in real estate and have their net worth tied to one property or one local market.
Concentration can be a great way to generate significant wealth, as long as the one company is the right company. Unfortunately, finding the right company can be hard without the clear-eyed vision of hindsight. Concentration can destroy wealth and we have seen enough examples over the last decade to heed the warnings – Enron, AIG, GM, Wachovia, and Bear Sterns. All seemed to be fantastic companies, until the day they weren’t. Individuals with high concentrations of their investments in the stocks of any of these companies saw how quickly money can disappear, with no likelihood of recovery in each case.
Business owners almost always say their best investments are in themselves and reinvesting in their own companies. Well, successful, high-earning business owners say that. The reality is that new businesses often fail within the first five years. Small business failures can be catastrophic to the entrepreneur as they are often funded with owner equity and some debt. Owners of failed businesses may walk away with less than nothing as they owe suppliers and lenders, in addition to losing their capital in the start-up and operation of the business. Concentration in one business does not look so good when the business turns sour.
Even successful entrepreneurs must make a decision about the best time to realize value from the enterprise. The environment for the business may change dramatically in a short period of time. Travel agencies used to dot the landscape of towns. Now, the only agencies remaining have targeted niches as most of us make our travel plans through online sites. Remember bookstores? How would you like to own one today? Even small changes may impact profitability that reduces the value of a business. A competitor might open just close enough to impact sales by 10% or more. There are plenty of reasons for entrepreneurs to reduce risk by diversifying their asset bases.
One recommendation is for the business owner to take money out of the business for other investments to provide diversification. This can happen inside a company sponsored retirement plan or outside the boundaries of the company into public markets, other business ventures or real estate. Over time, the goal is to reduce the concentration of assets in the one company and lower risk to the business owner’s financial life if there is some issue with the company.
Individuals who invest may also end up with a high degree of concentration in the portfolio. Again, this can work if the right company is chosen over the right period of time. During the first decade as a public company, shareholders of Microsoft were well rewarded. Even a young guy named Bill Gates did well with his highly concentrated position. Coca-Cola at times looks amazing. $13 invested in McDonald’s in 1994 is worth close to $90 this year. Many high quality companies preserved personal net worth through the tech bubble – especially companies in stable industries outside of technology.
Often, individuals wind up with these significant positions as a result of investing through workplace programs and having their employers grant or match funds with company shares. These assets tend to be left alone while working at the company. They look like great investments, again with the clarity of hindsight. These stocks most likely outpaced others in some years and trailed in others. The key to wealth accumulation was to keep money invested and add to it regularly.
We still have to ask the same question, “Is this the best way to invest?”
The answer, as you expect at this point, is “no.” Investors with most of their net worth in one company got lucky. They were in a company that survived. Most likely, they would have done fine by diversifying some of the position each year. They would certainly have avoided the fate of many that I have met that looked great on paper at one point, only to see it disappear as the company went bankrupt.
Investors with concentrated positions must address several issues to make a change to a broader investment basket. There are emotional ties that bind that person to the investment. The ties come in many forms. Employees might have spent 20 or 30 years with a company and look at the sale of stock as an act of disloyalty. The stock represents the significant investment of personal time and energy and the rewards represented by the stock. The stock is likely to be the one investment they remember owning over that time. It is hard to imagine a better investment as the one stock represents 30%, 40% or even more of total net worth. The stock may have been a gift from a parent.
Also, there are tax issues that must be addressed as a person seeks to reduce concentration of any one position – whether the sale of a business, stock or real estate holding. Sometimes it makes sense to whittle away at the concentrated position, taking five or more years to work through it and defer paying the total tax impact at once. In this case, it might make sense to use options and other hedges to minimize the risk while waiting to sell.
Earlier this year, I discussed the pride of ownership we should have by investing in companies. We look for companies with earnings growth trading at reasonable valuations and may add other factors – such as enjoying their products, respecting corporate leaders, approving of social responsibility and more. Concentrated portfolios often result from that sense of pride of ownership.
As investment managers, we seek to understand and minimize portfolio and financial planning risk. We might own Coca-Cola, Colgate-Palmolive, Exxon-Mobil, Apple and other companies in your portfolio. We know that diversified portfolios stand a better chance over a long period of time of generating wealth and income for you. We will make sure to review any positions we see in your assets that look to increase risk of concentration and work with you to develop a plan to address it.
Rob Wrubel CFP®, AIF®, is a Senior Vice President, Investments with Cascade Investment Group, member FINRA & SIPC. Cascade Investment Group is not a tax or legal advisor. You should always consult with your tax advisor or attorney before taking any actions that may have tax consequences.