What Causes Company-Specific Risk
Oftentimes, those who have accumulated significant wealth did so through the concentrated holdings of stock/option compensation from an employer, business ownership, a successful long-term investment, or inheritance.
This can mean their ability to fund their retirement can be contingent on the continued prosperity of a specific asset. Although this concentrated investment strategy allowed you to generate your current nest egg, it may not make sense from a risk/reward perspective to continue to hold these assets.
This is because holding a large percentage of your retirement portfolio in a single asset increases something known as “unsystematic” risk. Unsystematic or company-specific risk is an additional kind of risk you take on when investing in an undiversified asset.
To illustrate this point J.P. Morgan Asset Management published a report on how often a concentrated position would have underperformed the Russell 3000 Index from 1980 to 2020. They found about 2/3rds of the time, a concentrated holding in a single company would have underperformed a diversified holding in the Russell 3000 Index.
A potentially more alarming finding was approximately 40% of all Russell 3000 Index components lost at least 70% of their value and never recovered.
However, the potential permanent loss of value that comes from holding a single asset can be mitigated through diversification. Proper diversification can limit the risk you take to “just” the inherent risk that comes with investing in the market.
Potential Barriers to Reducing Company-Specific Risk
In theory, diversifying a concentrated holding should be a relatively straightforward process. You would simply sell a portion, or all, of the asset and invest the proceeds based on your long-term investment strategy.
In the real world, the diversification process can be more complex due to the following factors:
Many times, holdings in a single asset have large unrealized gains, as a result of years of compound growth. Selling this asset would create a large tax bill that many would find undesirable. As a result, many continue to defer the sale indefinitely due to their unwillingness to pay taxes.
Although, if the position happens to be in a tax-deferred or tax-free account, there will not be tax consequences on the sale of the position. The tax liability would not be a factor in this case.
The Endowment Effect
There is something known as the “endowment effect” where you value something more, simply because you own it. It could be the stock of a company you’ve worked at or your share of a business you started. Or this holding could have been inherited from a spouse, parent, or grandparent, and as a result, carries a strong emotional attachment.
This attachment can tilt your investment decisions. You may continue to hold the asset even if it doesn’t fit in your investment strategy.
Future Regret (FOMO)
Often you don’t want to sell an asset because you are afraid you will miss the opportunity of future gains. This is especially true with an investment you have seen have significant appreciation in value. You can become overconfident that this past success will continue into the future and will regret ever selling.
A Question to Ask Yourself When Thinking About Company-Specific Risk
With these barriers potentially clouding your judgment, we have found this question helpful when thinking about selling an asset.
“If you didn’t own this asset, but instead had the equivalent amount in cash, how much would you buy of it today?”
Let your answer dictate how you should proceed. If you would feel comfortable buying less than you currently own, or none at all, it may be time to create a diversification strategy.
Create a Diversification Strategy
Having a diversification strategy can allow you to incorporate the sale of this asset with the rest of your retirement plan. Depending on the size of the position, it may make sense to sell portions of the asset over a number of years. Doing this can allow you to spread your tax liability over time while still diversifying away from the position.
Also, the annual sales could be coordinated with your retirement cash flow plan. This could allow you to take advantage of other retirement income-boosting strategies such as delaying your Social Security benefit.
A final option for those who are charitably minded is to donate some, or all, of the assets to charity. By donating the financial asset held for more than 12 months, you can avoid paying capital gains taxes. In addition, your gift may be deductible for income tax purposes.
The company-specific risk that comes with concentrated holdings can be mitigated through diversification. However, the process of selling can have many nuances. Having a diversification strategy in place could be useful when making investment decisions that have tax and emotional implications.
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