The Importance of Diversification
Investors often seek to maximize returns by identifying and investing in stocks poised for outperformance. On a high level, choosing winners through stock picking requires both skill and (a lot of) luck. For most individual investors, repeating these success factors more consistently is a formidable challenge. Additionally, having a significant portion of your wealth attached to a handful of winners can bring its share of (good) problems (to solve). When these winners continue to climb higher, they eventually become more concentrated and pose a risk to retaining your wealth.
A study of a broad total stock market index, such as the Russell 3000 Index, can provide clues on the lifetime returns of individual stocks. Over time, as the fortunes of these big winners go up and down, a single concentrated, median stock often fails to beat the overall market. Over the last four decades, the median stock underperformed the Russell 3000 Index by more than 10%.
When an outsized winning, concentrated stock resides in a taxable account, it leads to another challenge — the taxes owed to Uncle Sam when you sell. Now investors must deal with concentrated stock risk and taxes from capital gains.
Understanding the Broad U.S. Market Index
The Russell 3000 Index encompasses the 3,000 largest publicly traded U.S. companies by their market-cap, representing approximately 98% of the investable U.S. equity market. This broad-based index provides a comprehensive snapshot of the market’s performance, including large-, mid-, and small-cap stocks.1
The Volatility and Impairment of Individual Stocks
A study by J.P. Morgan Asset Management analyzed the performance of individual stocks within the Russell 3000 Index from 1980 to 2020. The findings were striking: 42% of these stocks experienced an absolute negative return over their lifetimes, and 66% underperformed the broader index. This data underscores the high volatility and risk of impairment associated with individual stock holdings.2
The Challenge of Stock Selection
Given the significant proportion of stocks that underperform or incur losses when compared to the broad market index, investors aiming for outperformance through concentrated positions must possess exceptional stock picking abilities. The probability of selecting a stock that will outperform the market is relatively low, necessitating a strong conviction and thorough analysis to justify such positions.
The Benefits of Diversification
Diversification involves spreading investments across a wide range of market segments, such as firm size (large/mid/small), sectors (industrials/healthcare/technology, etc.), style (value/growth) and geography (U.S./developed/emerging markets) to reduce exposure to any single risk. By constructing a diversified portfolio, investors can mitigate the impact of poor-performing or highly successful but concentrated stocks and achieve more stable, risk-adjusted returns. The Russell 3000 Index itself serves as an example of diversification, encompassing a broad spectrum of companies across various sectors.
Approaches to Managing Concentrated Stock Holdings
Investors who hold a significant portion of their wealth in a single stock — whether due to stock-based compensation or substantial appreciation — can explore various strategies to mitigate concentration risk, including:
- Incremental diversification – Selling shares gradually over time helps reduce exposure while managing tax liabilities.
- Exchange funds – Contributing concentrated stock to a fund that pools assets from multiple investors allows for diversification without triggering immediate tax consequences.
- Charitable contributions – Donating stock to charitable organizations can provide tax advantages while reducing concentration risk.
- Advanced strategies – Systematically selling shares over time using derivatives and structured products and investing the proceeds in a diversified total stock market while offsetting the capital gains using tax-loss harvesting strategies, such as direct indexing and enhanced direct indexing.
The most suitable strategy depends on individual factors, such as tax considerations, financial objectives and risk tolerance.
While the allure of achieving substantial returns through concentrated stock positions is undeniable, the analysis of the Russell 3000 Index highlights the challenges and risks inherent in such an approach.
