Business

Diversified strategy can limit potential destruction of concentrated risk

Some of the richest people in the world have created their wealth by being entrepreneurial and concentrating their investment in one or two companies.

Other lucky investors have purchased the stocks of one or a few publicly-traded companies early in their history and kept these stocks for a long time.

But the paradox of this approach is that maintaining wealth is better accomplished with a more diversified strategy to limit the potential destruction of a concentrated risk.

Investing in individual stocks comes with more risk than you are likely aware.

Michael Cembalest, chairman of Market and Investment Strategy for J.P. Morgan, analyzed companies in the Russell 3000 Index going back to 1980. This index tracks the largest 3,000 publicly traded companies in the U.S., representing about 98 percent of the stock market. The index is reset annually.

From 1980 through 2014, 13,000 companies were members of the Russell 3000. That’s right, over the years, 10,000 publicly-traded companies disappeared from this index. Mergers or acquisitions absorbed some of these companies into others but many simply failed and were dropped from the index, replaced by new growing companies. In some cases, competition destroyed slow-to-evolve companies. In others, government policies or unforeseen circumstances eliminated a company’s ability to operate profitably. And it’s not just small companies you’ve never heard of that failed. Remember Blockbuster, Circuit City … the list of the once-prominent is long.

Roughly 40 percent of the 13,000 stocks that have been a part of the Russell 3000 experienced a permanent decline of 70 percent from their peak value at one time or another. They did not, or have not, meaningfully recovered their past glory.

Even many of those stocks that had a much higher rate of return than the market as a whole, didn’t experience consistent growth. Almost all stocks challenge their shareholders’ conviction at some point. Not many people will withstand declines of more than a third of share price — but it happens.

To highlight some locally prominent stocks, consider the experience of three companies that have generated significant wealth for long-term shareholders but have been severely beaten up along the way.

Starbucks had gained roughly 18,000 percent since first traded in June 1992 through the end of September. But from November 2006 through November 2008 its stock price declined by nearly 82 percent.

Microsoft’s stock price grew over 60,000 percent from March 1986. But Microsoft had two separate episodes with declines exceeding 60 percent (Dec. 27, 1999 to Dec. 29, 2000 and Nov. 1, 2007 to March 9, 2009).

Amazon has seen huge price gains year-to-date while the broad U.S. stock indexes have been battered. From May 1997 through the end of September its stock price rose by nearly 29,000 percent. Jeff Bezos’s retail and technology innovation hasn’t always been in good favor with the market however. From April 1999 to October 2001, Amazon’s stock declined 94.3 percent. A separate 65 percent stock price decline shook investors from October 2007 through November 2008 and a 29 percent drop ended nearly a year ago.

Typically only founders and early venture capital investors experience the massive gains from the start. And even they don’t capture all of the massive gains as they sell and capture profits from their initial investment on the way up.

Most people have a far different experience. Some hold on through the rise and fall but many buy near the peak of the rise and sell into the exceptional decline. Some people who have ill-timed buy-and-sell decisions know only the experience of losses amid the otherwise clear successes of the stocks they invest in.

It’s these declines that highlight the value of diversifying assets in order to maintain wealth.

The J.P. Morgan report suggests that “after incorporating the issue of single stock volatility, we find that 75 percent of all concentrated stockholders would have benefited from some amount of diversification.”

There are many ways to increase investment diversification. Simply owning a broad U.S. stock index is a first level of diversification from a concentrated U.S. stock position. Adding international stocks, bonds, real estate and other types of assets introduces more layers of diversification and potential risk management.

Especially if your concentrated position could have multi-generational effect on your family, you need to be clear about your goals for capital preservation vs. growth. As Cembalest writes, “the hard reality (is) that, all too often, continued concentration may ultimately destroy wealth.”

Of course, there are situations where risk is rewarded beyond imagination. But regardless of your approach to building financial security, it’s important to understand the fickle nature of even wildly successful investments.

Gary Brooks is a certified financial planner and the president of Brooks, Hughes & Jones, a registered investment adviser in Gig Harbor. Reach him at gary@bhjadvisors.com.

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