In February of this year, I was speaking with an advisor in Utah. We were discussing the use of a Stock Diversification Trust (click here to request an Advisor Guide) for a client who had 80% of her net worth in a single stock.
 
She was reluctant to sell because she felt emotionally attached. The trust would have allowed her to sell, diversify, and not pay capital gains tax. The advisor advised her that she should diversify. But she still didn’t sell.
 
The stock, Zions Bank, cratered when Silicon Valley Bank collapsed.
 
This example is noteworthy primarily because of the timing. The month after the client rejected the advisor’s advice to diversify, Zions Bank stock collapsed.

 
But I talk to advisors almost every week who have a similar story. A client holds an overweight position. The client knows that the “average” investor should diversify. But the client wants to hold onto his or her position because of some hard-to-explain feeling. We believe that feeling, that unexplained emotional attachment, is what psychologists (like Nobel Prize winner Daniel Kahneman) would call a cognitive bias. The cognitive bias is the belief that amounts to “it’s special.”
 
Except, of course, the stock is not special. At least not most of the time.
 
In fact, the risk of any given stock (looking forward, not using hindsight) having long run negative returns, is shockingly high.
 
That is the key finding of a study by Arizona State University’s Hendrik Bessembinder.[1]
 
Here’s the main takeaway: “57.8% of stocks… reduced, rather than increased, shareholder wealth.”
 
Let’s look at that again.
 
More than half of all stocks reduced shareholder wealth.
 
How is that possible?  Hasn’t the stock market generated an average long run compound return of about 10%?
 
Yes. But that emphatically does not mean that the average stock has generated that return.
 
In fact, the key Bessembinder finding is the opposite: the average stock (i.e. 57.8% of all stocks) actually reduced shareholder wealth. In other words, if you randomly choose one stock to invest in, there’s a 57.8% chance that you’ll lose money.
 
Based on the evidence from many advisors who have clients who won’t diversify a massively overweight position, many shareholders either don’t know, don’t understand, or just don’t care.
 
We have a theory, and hopefully a treatment, for this form of financial blindness.
 
Theory: Lake Wobegon Effect
The so-called Lake Wobegon Effect, named after the fictional town in which everyone is above average, has been documented in many areas. Most students think they are more popular than average (Zuckerman & Jost, 2001). Half of American drivers rated themselves in the top 20% of safety (Svenson, 1980). And a full 98% of high school students reported average or above leadership ability (Aronson, Wilson, Akert, 2010).
 
We want to suggest a corollary to the Lake Wobegon Effect. Let’s call it the “Mine is Different” effect.
 
“Congress is Terrible. But My Congressman is Good.”
The Gallup polling organization reports that “Americans overwhelmingly disapprove of the job Congress in general is doing, [yet] voters re-elect most members of Congress in every election. This phenomenon is partly explained by the finding that Americans have significantly more positive views of their own representative than they do of Congress overall.”
 
Mine is Different
Most people have some vague understanding that a concentrated position is riskier than a diversified portfolio.
 
But it seems that many act as though their concentrated position is special.
 
In the great majority of cases, the concentrated position is not special, at least not looking forward. It is, quite simply, extremely risky to keep a large fraction of your portfolio in one stock. Of course, if you knew ahead of time that you’d picked a “winner”, this would be a good strategy, but most people don’t pick the winners.
 
And for stocks that have done very well, it might be even worse precisely because most of the very high rate of return is in the past. Even the genius Warren Buffet has not sustained the high rates of return he earned when his company, Berkshire Hathaway, was small. From 1965 to 1998, the annual compound return to owners of Berkshire was 30%.
 
And while Buffet has continued to perform well, from 1998 to 2022, the annual compound return to owners of Berkshire was just about 8%. Not bad, but just about what the S&P 500 returned. However, the long run volatility (measured as standard deviation of return) of Berkshire Hathaway has averaged over 19% during that period, compared to less than 16% for the S&P 500.
 
In other words, even though Berkshire Hathaway has been one of the most successful companies in history, and even though it is run by the man who is arguably the greatest investor ever, since 1998, Berkshire Hathaway, on a risk adjusted basis, has underperformed the S&P 500.
 
Even, or perhaps especially, if you own a large position in a company that has done very well, diversification is, from a risk management perspective, a “no brainer.”
 
In the words of Adam Farago “most stocks deliver very poor returns while a few deliver exceptionally large returns. Second, this extreme skewness is quickly reduced through diversification (e.g., with 50 stocks in the portfolio).”[2]  
 
Cure: Sell and Diversify Without Taxes
The emotional reasons to hold a concentrated position are not logically valid.
 
But the desire to not pay a large capital gains tax is quite logical.
 
One excellent solution to the problem of capital gains tax is the use of a Stock Diversification Trust. When appropriate, a Stock Diversification Trust allows the client – or the advisor – to sell the stock, pay no capital gain tax, and reinvest in a diversified portfolio. It also often allows an advisor to convert a non-AUM asset – the client’s concentrated position – into managed AUM.
 
To learn more about how you can use a Stock Diversification Trust for your clients, please call 703 437 9720 and ask for Connor or Katherine, or email [email protected], or click here to request a free copy of our Advisor Guide: Concentrated Stock Positions.