Excess Risk
Just as most people would like to earn excess returns, few people want to incur excess risk. Excess risk is risk that you take that is greater than the amount of risk you would have if you owned “the market.” In the case of the U.S., the S&P 500 is considered representative of “the market.”
Financial theory measures risk in a variety of ways. One of the most common ways is called the standard deviation of return. The standard deviation of return is a mathematical measurement of volatility, or how much returns bounce around.
The following chart illustrates two assets that have approximately the same long run return, but different volatilities.
The value of the stock index bounces around much less than that of the single stock. While not every stock carries excess volatility, most do.
Using the math of finance theory, it can be proven that a concentrated position results in a portfolio that carries excess risk. Excess risk, in financial theory terms, is risk that you could diversify away. For example, instead of owning one stock that constitutes 20% of your portfolio, if you adjusted your portfolio so that no stock constituted more than, say, 2% of your portfolio, you’d eliminate excess risk without giving up much expected return.
If concentrated positions generate excess risk, why do people hold them? Let’s look at some reasons.
Why Do People Hold Concentrated Positions?
While there are probably as many reasons for holding concentrated positions as there are investors who hold them, we have identified four main reasons people hold concentrated positions. These are:
– Expectation of Outsize Gains
– Control
– Aversion to Taxes
– Status Quo Bias
In this article, we’ll look at the first two reasons: Expectation of Outsized Gains, and Control.
Outsized Gains
Many of the great fortunes of history have been made by people who owned concentrated positions, usually in a single stock. Examples range from famous 19th century industrialists like John D. Rockefeller and Andrew Carnegie, to 20th century entrepreneurs like Henry Ford and Bill Gates, to 21st century tech founders like Mark Zuckerberg and Elon Musk.
These owners, and many others like them, may have felt more comfortable keeping large positions because they had, as CEO, controlling shareholders, and/or Chairman, a significant amount of influence on the business.
Nevertheless, many or most of them choose at some time to take a large amount of money off the table. That is, they reduce the size of their concentrated position, exactly so that they can diversify their portfolios. In 2021, for example, Zuckerberg sold about $4.5 billion of stock in Facebook; Jeff Bezos sold over $9 billion of his Amazon stock; Elon Musk sold an estimated $11 billion.
The hope of earning further above-market gains is one important financial reason people hold concentrated positions.
Control
Control, and the desire to maintain control, is another reason people may hold concentrated positions, even if doing so potentially exposes them to excess risk. Control investors who wish to reduce their positions may have alternatives that are beyond the scope of this discussion.
In a future article, we’ll examine two additional reasons people fail to diversify their portfolios: aversion to taxes and status quo bias.
If you’d like to understand specifics of finance theory for excess risk, apply for an early copy of The Intelligent Layman’s Guide to Personal Investing, forthcoming from Wiley. Click here to be added to the list. You might win a prepublication review copy. Or call 703 437 9720 and ask for Connor or Dave.