Making periodic adjustments to your portfolio can ensure that you remain diversified, and don’t end up too heavily weighted in one stock.
Question: I try to keep a diversified portfolio and maintain a buy-and-hold strategy. But one stock I bought has done so well that it now represents more than half the value of my portfolio. I don’t want to mess with one of my better investments, but I’m wondering whether I should sell off some of my position. What do you think? —D.W., Naperville, Illinois
Answer: I know that some people might say the answer to your question comes down to whether your hot stock is likely to keep climbing. After all, if the outlook is good, why sell if it still has more room to run?
But while periodically assessing the future prospects for a stock – or, for that matter, any investment – always makes sense, I think the bigger issue here is how much of your portfolio should be riding on the fortunes of any single stock, even if its future appears bright.
As it turns out, this is an issue I’ve had some personal experience with in my 401(k). A very costly experience. Maybe sharing it with you will spare you the expense of going through a similar ordeal on your own.
Throughout the ‘80s and ‘90s, I acquired quite a few shares of Time Warner stock in my 401(k). Not because I bought it, but because my employer’s matching contribution came in the form of company shares. As Time Warner stock began to soar in the go-go ‘90s, so too did the value of my 401(k). By the time the AOL-Time Warner deal was announced in January, 2000, right at the peak of the dot-com craze, my stake in the combined AOL Time Warner represented more than half the value of my 401(k).
I remember thinking at the time how ironic it was that I should benefit so handsomely from gains in just one stock when I had always advised against holding a large concentration of company stock in a 401(k), or any single stock in any portfolio, for that matter.
But under our 401(k) plan rules at the time, I was prohibited from selling shares that the company contributed. So like it or not I was along for the ride. And given all the hype and hoopla at the time about the limitless possibilities of the dawning digital world, it seemed the ride would continue to be quite a profitable one.
And then reality intruded, exposing the bombast of the New Era crowd and reversing the trajectory of absurdly priced stocks. I watched in horror as my shares lost more and value, but I couldn’t sell since the plan rules locked me in. Eventually, the company relented and gave us the option of selling company-match shares if we wished. But by that time, the damage was done – my 401(k) had lost roughly half its value, with the bulk of the damage due to the collapse of Time Warner stock, which eventually fell 90% from its high.
Which brings us back to your case. I’m not predicting that doom awaits if you keep your current holdings of your hot stock. But you are taking on substantially more risk. The reason is that although volatility can vary widely from one stock to another, a single stock is generally two to three times more volatile than a diversified portfolio of stocks. Bottom line: having a big chunk of your money in one stock increases the volatility of your portfolio overall.
That volatility can work in your favor when all goes well, leading to gigantic returns. But it can also result in lower lows if your hot stock fizzles. On average, though, a portfolio that contains a large position in one stock will underperform a diversified one.
You can argue about how much of one stock is too much. But I certainly think that once a single stock accounts for more than 10% of your portfolio, you’re pushing it. And if it exceeds 20% of your portfolio I think you’re asking for trouble.
One important difference between your situation and the one I faced years ago was that you aren’t locked in. You can pare back your holdings if you wish. And that’s just what I think you should do: start selling shares and spread the proceeds among the rest of your portfolio. Yes, you’ll have to pay tax if the stock is held within a taxable account. But if you’re unloading shares you’ve held more than a year, you’ll be taxed at the long-term capital gains rate. So you’re talking about a 15% hit at most. Once you get your position down to a manageable level, you can avoid this problem in the future by rebalancing your portfolio periodically.
By the way, this advice also applies to people who own company stock in a 401(k). A recent evaluation of the holdings of nearly one million 401(k) participants by Financial Engines found that even after the Enron fiasco more than a third of people whose plans include employer shares as an investment option have more than 20% of their 401(k) assets in unrestricted company stock. And some hold much, much more.
Frankly, I don’t see any compelling rationale to keep company stock in your 401(k) if you can avoid it. One possible exception: if you’ve already accumulated lots of shares that have appreciated substantially over the years, you may want to consider holding onto them to take advantage of a tax-lowering tactic that exploits the shares’ NUA (net unrealized appreciation), or the difference between what you paid for the shares and what they’re worth now.
Just to close the loop on the sad saga of my 401(k), I’m happy to report that it’s largely recovered, and the only Time Warner shares I own now are ones that were bought by one of the diversified funds I hold in the plan. Not that I don’t have faith in my esteemed employer. It’s just that when it comes to investing money – and particularly retirement savings – I believe in the power of diversification a lot more.
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