Losing your Concentration ... Risk

Author’s Note: This article is Part 2 of my series on Concentration Risk. Part 1 covered what it is, how it happens, and why it’s sometimes hard to get out of.

A concentrated position is when a significant portion of your net worth is tied to a single asset. Concentrated positions are bad because they involve taking on more risk than is necessary for equivalent returns in a diversified portfolio. The rational part of our brain knows this, but our cognitive biases often prevent us from acting on this knowledge. In this article I outline how to plan and execute the diversification of a concentrated position.

Let’s consider a somewhat oversimplified example to illustrate this: Chris is an employee at ABC Corp, a widget-maker. Chris owns 10,000 shares of ABC Corp, currently priced at $20/sh.

In addition, Chris has $200,000 in other investments. Chris’s position in ABC Corp. is a concentrated position representing 50% of net worth.

The Plan

It’s important to have a rigorous plan when fighting your cognitive biases. Otherwise you’ll find yourself losing faith when things go differently than you expected them to.

Step 1: Build a Financial Plan

A solid financial plan is a prerequisite to any decisions about portfolio allocation. There’s no such thing as a one-size-fits-all portfolio because everyone has different needs, time horizons, and risk tolerance. Your financial plan should account for your:

• Assets and Income: What assets you have, and what you expect your future inflows to look like.

• Needs and Time Horizon: For example, you might want to buy a house in 2 years, send 2 kids to college in 15, and retire in 22. Your assets should be invested in a manner that maximizes returns and minimizes risk for those timelines.

• Risk Tolerance: We can each tolerate different amounts of risk. In my experience, most people overestimate their risk tolerance. You might tell yourself that your response to the market dropping 20% will be to buy more, but at the beginning of 2023 find yourself considering going to cash or waiting for the “right time” to buy in. (Don’t lie! We have the data for how much cash many of you have stockpiled!)

• Risk Capacity: Risk tolerance is how much risk you can stomach; risk capacity looks at your available assets and asks if you have a strong enough base to pursue higher risk activities. You should only take larger risk with assets you can demonstrably afford to lose (or underperform).

  
  

The outcome of this exercise will be a target asset allocation that puts you on the best track to meet your goals.

For our oversimplified example, we’re going to assume that Chris expects to retire in 20 years, has no other needs to fund, and is expecting their current $400,000 net worth to grow to $1M over that time. An expected growth rate of 5% puts them right on track to do that.

Step 2: Valuation

The next step is to determine a value for the asset. If you have a concentrated position in an asset, it’s very likely that you also have strong opinions about how to value it because of your insights into the company or industry. In order to develop a plan that you will continue to believe in, it is important that you have a way to value the asset that incorporates your insights.

Most valuation models are either intrinsic (based on future cash flows), or relative (based on the price of similar assets). Intrinsic valuation models tend to be more robust and less subject to the whims of the market, but harder to create, than relative valuation models. Both approaches provide ways to add your own input.

Ideally, your valuation model will produce a target value and an associated estimate of uncertainty, or risk.

Intrinsic Valuation:
ABC Corp has no debt. It currently earns $0.43/sh from its Widgets business, which Chris expects to grow 20% per year for the next 5 years before leveling off. They are also currently developing a new line of Sprockets. Chris expects this business to grow to 50% of the Widgets business in 10 years.

Using the Discounted Cash Flow method of valuation, and factoring in some uncertainty with the new line of business, we get a Fair Market Value of $25/sh for ABC Corp, and a Beta of 1.5.

Relative Valuation:
Alternatively, we can consider a relative valuation method. The current players in the field are:

A relative valuation, which looks at Price to Earnings ratios and growth rates for others in the industry, says ABC Corp. is fairly valued at $20/sh. Factoring in Chris’s bullishness about the Sprockets business, we arrive at a valuation of $25/sh, and a Beta of 1.5.

Note: I made up this example so that the intrinsic and relative valuations arrived at the same number. This is rare in practice.

Our conclusion here is that ABC is undervalued at $20/sh since we believe it should be valued at $25/sh.

Step 3: Target Asset Allocation

Your financial plan, combined with your valuation model and associated risk, should equip you to determine an ideal allocation for your concentrated investment. This is somewhat easy if you believe that the market is overpricing, or even fairly pricing, the asset: Your target allocation for it as a standalone asset will be 0. (You might continue to be exposed to the asset as part of a broad index or actively managed strategy but won't hold it on its own.)

It’s a bit more complicated if you believe that the market is underpricing the asset, as you will need to factor in the extent of the undervaluation, the uncertainty around it, and your overall needs, time horizon and risk profile to determine the best asset allocation for you.

For our example, we conclude that Chris should target a 20% allocation in ABC Corp., with the remaining 80% being allocated to a broad index fund.

Execution

Once you have your target asset allocation, the next phase is to get to it.

One Shot

If your target asset allocation is relatively close to your current allocation, or if the amounts involved are not very large, this can be a single step where you sell off your concentrated position and replace it with the appropriate asset classes according to your plan.

Market Risk

If your current asset allocation is quite different from your target, and if the amounts involved are significant, you will want to minimize the market risk by spreading out the conversion over multiple transactions. You wouldn’t want to happen to pick the one moment in history when the asset you’re diversifying from is underpriced compared to the assets you’re converting to. Depending on the numbers involved, this could mean executing the conversion in the form of multiple trades spread out over multiple months.

Iteration

Diversifying over a period of time is an iterative process:

• Fluctuations in the asset price will affect your target asset allocation as well as how much you need to sell to hit your target. A nice feature of this is that you will end up selling more when the price is high and less when the price is low.

• Material changes might also influence your valuation model. For example, if you believed a stock was underpriced because the market was undervaluing a new AI-based growth strategy, the confirmation of your hypothesis will affect whether you think the asset is still undervalued. Similarly, entirely new announcements and developments will also change how undervalued you think the asset is.

• Changes in your personal situation will affect your financial plan and might affect your risk tolerance or needs.

All of these will affect your target asset allocation and your execution plan will need to adjust accordingly.

It’s very important to have a solid valuation model when re-valuing your assets to avoid getting swept up in market sentiment yourself. Perhaps, during your initial evaluation, you believed that the market was underpricing a company because it was undervaluing a new product line. Once the market corrects this, the price of its stock will rise. It will be easy for you to get swept away in this exuberance and adjust your own valuations upward, when it’s actually time for you to sell more.

Taxes

Your diversification strategy should also factor in the most tax advantageous way to time and pick specific lots to trade based on the purchase price, and how long the assets have been held.

Insider Trading

If you’re still associated with the company, you will also need to execute your trades within appropriate trading windows, or use a 10b5-1 plan to comply with insider trading regulations.

Sticking With It

Your execution plan should account for your cognitive biases conspiring against you. Just as having a written exercise plan, a gym buddy or personal trainer increases the likelihood that you will stick with a new fitness regimen, having a written strategy, regularly discussing your strategy with people who can keep you accountable, or hiring a professional, will increase the likelihood that you will successfully execute your diversification strategy.

Also, while it is possible to create a strong fitness or investment plan on your own, working with a professional will likely lead to better results.

Market Risk: For our example, we’re going to assume that we decide to get to the target 20% allocation by selling 750 shares each quarter for the next 8 quarters.

Taxes: Let’s say that the 10,000 shares Chris owns were acquired in the following lots:

We would choose to sell shares from the Dec 2021 and Dec 2020 lots first, and then some shares from the Dec 2022 lot. We would also ensure that the Dec 2022 shares were held for at least 1 year to ensure the gains are treated as long-term capital gains.

Trading Windows: Since Chris is currently employed at ABC Corp, we will ensure that we are in compliance with insider trading regulations by only selling stock in the designated period after earnings announcements each quarter. If Chris’s situation had been more complex, we could have filed 10b5-1 plans to allow these trades to occur at other periods also

Iteration: If, at some point over the next two years, ABC Corp’s share price rose closer to our then valuation, we would respond by reducing our asset allocation for ABC. For example, if the share price rose to $25 while our valuation rose to $27, we might conclude that we now only want to allocate 10% of our assets to ABC Corp.
On the other hand, if the share price fell, or our valuation rose, we could set a higher target asset allocation and hold off on some of our sales as a result of that.

Prospero Can Help

Prospero Wealth is a planning-centric wealth manager. We build bespoke financial plans and asset strategies for tech workers, entrepreneurs, and healthcare workers. We can help you with every step of the diversification process.

Planning

Every engagement with Prospero starts with a Financial Plan. We believe that your investment strategy must be based on an understanding of your assets, needs, and risk profile. We can also help you build a valuation model that incorporates your expertise, and help you determine your ideal asset allocation.

Asset Management

We can help execute your plan, including performing the transactions with the appropriate lots at the right times. We also have access to Direct Indexing products which allow you to realize value through automated tax loss harvesting and rules-based selling, and Active Management Strategies that can generate additional alpha. Depending on your financial plan, we would diversify your assets into the most appropriate investments for you.

Questions? Comments? Did I miss anything? Feel free to reach out to me at suhas@prosperowealth.com if you’d like to discuss anything in this article. I’d love to hear from you.