One of the mistakes that investors make is holding a concentrated position in a company’s stock. (I’ll define concentrated as representing more than 10% of your liquid net worth.) The two most common ways people end up with a concentrated position is either they worked at the company or because they inherited their shares from a loved one. In either of these two scenarios, the reasons for continuing to hold the shares tend to be much more of an emotional decision than one based on achieving financial goals.
In the case of inherited shares, clients will often feel like they’re betraying what the person who originally bought the shares would have done. They say things like “I got these from Dad and he never would have sold these for less than $20 a share”, or “I just want to keep these as a way of remembering this person.” There’s nothing wrong with either of those statements as long as it’s not such a large percentage of your portfolio that, if the company goes bankrupt, it would prevent you from accomplishing your goals.
Many companies will offer the ability to purchase shares or will grant stock options to the employees as a way to incentivize them and align employee interests with shareholder interests. It might seem like a great way for you to share in the profits of your employer. It’s important to be realistic though and take into account the fact that every year, lots of companies go out of business and you have no way of really knowing whether your company is doing well or not. Worldcom had 30,000 employees. Of those 30,000, how many people truly understood that the company’s fraudulent accounting would ultimately drive that company into bankruptcy? Probably not many.
While owning a concentrated stock position has been one of the major sources of wealth for many famous families (insert the name of your favorite billionaire), it’s not a risk that most people can afford to take. Pick a famous fortune and, while many of them have owned concentrated stock positions, they’ve almost all been wise enough to sell enough stock so that no matter what happens to the price of their shares, they and their families will be just fine. You should never risk more than you can afford to lose.
By diversifying into a broad basket of stocks, you might not make a killing, but you likely won’t get killed.