Transcript

David Eldreth: Over time, some investors accumulate large allocations representing a significant portion of their wealth in a single investment. While investors and advisors generally understand that type of strategy can come with increased risk, the cost of selling off large allocations and the benefit of taking a more diversified approach are tough to quantify.

Recently, Vanguard researchers examined the implications of concentrated holdings and analyzed historical returns to evaluate the costs and benefits of concentrated asset allocations versus taking a more diversified approach. The research paper, titled Is Dilution the Solution? Considerations for a Concentrated Equity Portfolio, can be found on our website.

I’m Dave Eldreth, and welcome to Vanguard’s Investment Commentary Podcast series. In this month’s episode, which we’re taping on August 14, 2018, we’ll discuss what you should think about before taking on concentrated equity positions in your portfolio. Joining us today is one of the paper’s authors, Jonathan Kahler. He’s an investment analyst with Vanguard U.S. Wealth Planning Research Group. Thanks for joining us today, Jonathan.

Jonathan Kahler: You’re welcome. It’s good to be here.

David Eldreth: Jonathan, before we dig into what our research says about allocating significantportions of your portfolio to a single investment, can you offer an example of why an investor might fit this profile and why they might have a high equity position in a single investment?

Jonathan Kahler: Sure, that’s a great place to start. I think it might be useful to make a distinction in terms of intention. So on the one hand, you may have a really measured approach where someone has a concentrated position or a concentrated portfolio in order to express a really strong conviction in a particular stock or group of stocks. And that’s one issue. If that’s a risk-controlled process around that, that’s fine. What we see, really, more often with clients is concentrated positions that develop as a result of circumstances, whether that’s employer stock from a current or former employer that’s developed over time or just a portfolio that maybe has not been rebalanced in a long time and stocks that have done well, stocks that have maybe not done so well, so you have particular positions that grow to be an outsized concentration in the portfolio without really intentionally making that decision.

David Eldreth: What are some of the implications if an investor does have a high asset allocation in a particular holding?

Jonathan Kahler: I think at base level, you’re adding a lot of risk to the portfolio. That could be intentional in a risk/return trade-off, but oftentimes you’re looking at a portfolio where that’s not an intentional bet, and that risk is really not desired. So you could have a lot of volatility added to the portfolio and those price swings could be very stressful to an investor. You also run the risk of a permanent “risk of loss” in a portfolio if that stock consistently underperforms or even goes bankrupt. You could run that risk as well.

David Eldreth: Do we find that some investors often don’t understand the implications of having some of these holdings in their portfolio?

Jonathan Kahler: Yeah, I think it’s important that they do understand what risks they’re taking on. On the one hand, you could have quite a bit of volatility with large portions of individual stock in the portfolio. That could add unnecessary added stress to an investor as they see their portfolio go through these extreme price fluctuations. If it is the case of employer stock, that’s a special situation where you have correlated risks that you should really be concerned about. And what I mean by that, that correlated risk, is that you have a situation where your human capital—your ability to earn a living—is tied up in the same kind of risks as your investment capital, money that you may have saved aside for future retirement or other goals.

One really unfortunate example of that could be, going back a few years, Enron, where you saw a lot of people lose their job, but then also half of their retirement savings as well that was tied up in that employer stock.

David Eldreth: Now, clearly there’s a number of downsides with what you’re talking about with high asset allocation on a particular holding. But are there potential upsides as well?

Jonathan Kahler: Yeah, so there could be upsides as well. So if you are making that risk-controlled conviction bet on a stock, that’s a situation where you’re looking to have that risk/ reward trade-off. Not necessarily an upside, but you could be limiting other potential costs. A lot of times, these positions are in the portfolio really from a tax-driven perspective. We see investors that have these concentrations that build over time, and the cost to sell out of those positions and diversify into a broader investment would require a tax cost to do that.

So that’s where we see a lot of those tax implications driving investment decisions, and that’s where investors can sometimes run into trouble. And you look at that cost that’s really easy to calculate. It’s a known cost. Investors can see the impact of that decision, whereas the diversification benefit is really more abstract. They may know that there’s some risk there that they’re taking on, but it’s hard to quantify exactly what that means and what the alternative is.

That was one reason that we wanted to write this paper is to really explore those options and present a quantitative framework where we could really trade off the risk of selling out of the position and taking on those transaction costs or tax costs versus the diversification benefit that the portfolio’s going to get down the road.

David Eldreth: Sure. Now, other variables like age, does that come into play with whether it makes sense for an investor to have a high allocation of a particular holding?

Jonathan Kahler: Yes, absolutely. On the one hand, as we age, we generally have less tolerance for risk. On the other hand, as investors get older, more estate-planning considerations may come into play. So there may be discussions around basis planning where we’re not just deferring those taxes, but we can potentially eliminate those gains taxes through basis planning, where we would get a step-up when those assets are transferred to our heirs. So that may be a consideration investors are taking into account. Also, the opportunity for charitable giving. If you think about an investor that has a goal of transferring assets to a charity, appreciated stock positions are really a great first place to look.

David Eldreth: Sure, absolutely. Now if an investor is insistent upon putting money into a specific investment, are there guidelines for what we’d recommend as a maximum allocation in that case? Rules of thumb per se?

Jonathan Kahler: Yeah, that’s a good question, and it’s really somewhat hard to answer. It’s really going to depend on a lot of individual investor circumstances. What one investor may deem a reasonable risk for deferring or delaying those tax costs might not be an acceptable risk for another investor. And it’s going to depend on what their expected time horizon is for the investment. It’ll depend on what other assets that they have to accomplish their goals.

Generally speaking, if an advisor is looking through a portfolio of clients, 10% is a good starting point where you would at least want to look at that portfolio and have that conversation with a client so that they understand what kind of risks that they’re taking on.

David Eldreth: Now, when we talk about diversification, can you walk our listeners through that a little bit? When we say diversified, does that mean if I’m 60/40 domestic to international, that I’m diversified?

Jonathan Kahler: Yeah, and that’s a good point, because diversification can come in many forms, right? So we’ve talked about diversification in terms of single stock risk; but really diversification is the process of reducing or eliminating any risk that we’re not compensated for. So that could come in the form of sector risk. It could come in the form of geographic risk, other types of risk that may be inherent to a portfolio.

So looking across the portfolio, an investor may be 60/40 and see that as diversified from a stock-to-bond perspective. But if a large portion of those stocks are all coming from one industry or one sector of the market, that might be something to look out for.

Similarly, geographic diversification, if an investor has a particular home bias to their portfolio and they’re not getting that international diversification, that’s something to consider as well.

Something that’s often overlooked and something where advisors can add some value is with tax diversification as well. When we think of risk to the portfolio, one that we don’t really appreciate enough in a lot of cases is tax and policy risk. It’s not something that we have a lot of control over as investors, but one way that we can respond to changes in the tax code or changes to the makeup of our own income is to have diversification across account types for our portfolios. That means having monies in taxable accounts, having monies in accounts that have different tax treatment, so a traditional IRA or Roth IRA, and that way as we make portfolio decisions down the road, we can respond to some of those tax and policy changes that might occur.

David Eldreth: So, finally, Jonathan, when advisors and their clients are going through the process of reviewing their portfolios, how can they make sure there isn’t too much concentration in any one area?

Jonathan Kahler: Yeah, that’s an aspect of this where an advisor can really add quite a bit of value. When we think of being able to analyze that portfolio and helping the investor understand what risks they are taking, a lot of times that’s not really evident at first glance. So having screens or using software that can analyze that portfolio and help a client and the advisor understand: where they may be overweight relative to the market, where they might be underweight, to really understand what risks do I have, what overweights am I taking, are those intentional/are they not, is it something I expect to be compensated for, is it not, in really making those adjustments going forward.

David Eldreth: OK. Well, finally, Jonathan, is there anything that advisors and their clients can do when they’re going through the process of reviewing their portfolio to make sure there isn’t too much concentration in any one area?

Jonathan Kahler: Yeah, that’s a good question. I think that’s really something that’s core to the advisor/client relationship, being able to provide that analysis to a client and help them understand what risks they might be taking on that may not be immediately apparent. So there’s a lot of software that can help with that, but I think it’s good to have good screens in place, good processes in place where advisors can help those clients to identify those risks and understand what the impact or potential impact to the portfolio may be.

David Eldreth: That’s great insight, Jonathan. Thanks for joining us for this Vanguard Investment Commentary podcast and sharing your insights.

Jonathan Kahler: You’re welcome. Thanks for having me.

David Eldreth: To learn more about Vanguard’s thoughts on various financial planning topics, check out our website and be sure to check back with us each month for more insights into the markets and investing. Remember, you can always follow us on LinkedIn and Twitter. Thanks for listening.

Notes:

All investments are subject to risk, including the possible loss of the money you invest.

There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.

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

Funds that concentrate on a relatively narrow market sector face the risk of higher share price volatility.

We recommend that you consult a tax or financial advisor about your individual situation.

The information presented in this podcast is intended for educational purposes only and does not take into consideration your personal circumstances or other factors that may be important in making investment decisions.

You may access and download this podcast only for your personal and noncommercial use. You may not use it in any other manner or for any other purpose without Vanguard’s written permission.

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