Consider the bad luck of investors in BT and Pearson. For anyone with a substantial holding in either of these blue chip stocks, fourth-quarter results season, which recently ended, was a painful experience. Shares in both companies slid more than 20% after management issued shock profit warnings.
An accounting issue in BT’s Italian businesses led to a £145m write-down. More than £7bn was wiped off its market capitalisation on January 24th alone. While long term shareholders have seen good total returns, the share price slide would still have been a shock. Similarly, publisher Pearson’s market value fell by £2bn on 18th January after it revealed its US business was struggling and the dividend would be cut. Although both shares have recovered some ground, they have yet to return to previous levels.
For investors with a well-diversified portfolio, results season can be a time to sit back and take stock of the health of corporate earnings. But for those with larger single stock holdings, awaiting their company’s update can be an anxious time.
Why would you only hold one share?
In most cases, it’s not through design; perhaps the holding was inherited or the result of a generous management incentive scheme. It can seem like a good idea to hold on - particularly if a stock has performed well in the past or pays a big dividend - and alternatives can look unattractive. Selling up might leave investors with a large capital gain and the resultant tax bill off-putting. That is until something goes wrong and the true risks of being so aligned to one company’s prospects become apparent.
While share incentive programmes can have their advantages, there can be significant downsides. Owning a substantial holding in their employer leaves investors doubly-exposed to its fortunes. Not only could they lose their job but their investments could also be hit.
A lesson from Enron
The story of Enron employees never having sold a share losing everything as the company collapsed is well known. Not only did they lose their jobs, many of them also lost their entire life’s savings. Retired Enron employees were forced to return to work in their twilight years or sell their homes as their pension plans became worthless. Misplaced loyalty meant numerous employees had invested their pensions in Enron stock rather than establishing diversified investment portfolios. Enron is an extreme example, however, the point remains; placing all your investment eggs in one basket is often unwise.
The importance of diversification
While holding a concentrated single stock portfolio can lead to returns well in excess of wider markets, this isn’t always the case and for those potentially higher returns you are taking on considerably more risk.
By adding a well-diversified portfolio to a single stock position it may be possible to reduce substantially the portfolio’s overall risk profile and, in many cases, increase risk-adjusted returns. Below we have continued the example of BT, showing the stock performance over the last three years, as well as a globally-diversified balanced portfolio and a portfolio made up of 50% BT stock and 50% of the balanced portfolio.
At times holding the single stock would have resulted in significantly higher returns. However, the volatility of those returns is considerably higher and when shocks occur there is no protection from other assets to dampen the impact. By adding in 50% exposure to a balanced portfolio the impact of these shocks is reduced and overall returns are improved.
Source: Bloomberg, Netwealth
When should I sell my holding?
It is usually best to exit share incentive programmes as soon as possible to reduce the risk of over-exposure to one company’s stock. Investors should also ask themselves whether they would feel comfortable buying more of the same stock today. If not, then it may well be sensible to begin chipping away at the position and diversifying your portfolio.
If you have any questions about how you can ensure you are making the most of your investments, please give us a call on 020 3795 4747.
Please remember when investing your capital is at risk. The value of your investments may go down as well as up, so you could get less than you invested.