Part math, part emotion

Stocks are volatile by nature, and highly concentrated portfolios can expose you to extreme price swings and the risk of permanent loss. Diversification can limit these risks. Of course, diversification also limits the opportunity for exceptional outperformance.

In our research paper, Is Dilution the Solution? Considerations for a Concentrated Equity Portfolio, we analyze the tradeoffs between risk, return expectations, and any tax or transaction costs.

Jonathan Kahler
Jonathan Kahler

“Whether you should sell is part math, part emotion,” said Jonathan Kahler, a wealth planning specialist. “So a good place to start is to determine how likely that strong stock performer from the past will continue to beat the market in the future.”

The table below shows a glimpse of how likely future outperformance may be. We looked at individual stock performance over two 5-year periods for stocks in the Russell 3000E, a U.S. broad market equity index. The table shows how stocks from the first period (May 2008–May 2013) fared over the subsequent 5-year period ending in May 2018. Of the top quintile (20%) performers during the first period, only 18.1% remained in the top quintile over the following 5-year stretch. The majority of these past winners (55%) recorded negative excess returns over the subsequent period.

Table 1: Past performance is no guarantee of future results

  

Subsequent period performance quintile

 
  

Quintile 1

Quintile 2

Quintile 3

Quintile 4

Quintile 5

No longer in index

Initial
period
performance
quintile

Quintile 1

18.1%

20.3%

21.0%

15.0%

7.9%

17.6%

Quintile 2

18.5%

22.6%

19.2%

12.9%

5.2%

21.6%

Quintile 3

18.3%

17.8%

15.3%

10.5%

9.0%

29.1%

Quintile 4

19.6%

14.3%

13.0%

13.1%

15.8%

24.2%

Quintile 5

11.0%

5.2%

6.3%

10.6%

21.6%

45.3%

Source: Vanguard calculations with data from Factset.

Notes: 3,597 stocks were active across both 5-year periods. 1,368 stocks showing a return for the first period were no longer in the index over the full second period as a result of mergers, bankruptcy, or other corporate actions.

A good problem to have

Deciding what to do with healthy capital gains is a good problem to have. But it does raise a dilemma. Should I sell and diversify my holding, accepting the tax hit? Or hold on to the stock (and the risk) but defer the tax costs to a later date?

“Our research suggests that, more often than not, dilution is the solution. So, most investors would likely be better off selling their highly concentrated individual stocks,” said Kahler.

Of course, there may be exceptions. “Individual circumstances such as a high risk tolerance, large transaction costs, or a shorter-than-expected holding period can sometimes justify concentration. While these decisions can be difficult, having a clear understanding of the risks and rewards can help you move forward with greater confidence,” Kahler said.

Notes:

All investing is subject to risk, including the possible loss of the money you invest.

Diversification does not ensure a profit or protect against a loss.