You have all heard this a thousand times! “Don’t put all your eggs in one basket” has been around a long time and simply talks to diversification as a means of risk reduction. It is quite common for investors to have an emotional or other attraction to an individual stock or sector and request us to maintain/invest in a specific position and D&A has seen this from its clients over the years. Following is a real case study of my personal experience (and how it went wrong!)
My wife worked for Verizon (VZ) for 30 years and got VZ shares as part of her 401-k package. Verizon shares were used to match contributions so the balance grew quite large over time. We were careful to trade out of the VZ shares periodically to ensure that the position did not grow too large, but we kept some shares so that we could take advantage of the Net Unrealized Appreciation (NUA) tax benefit (i.e., NUA allows the company shares to be taxed as long term capital gains instead of ordinary income upon distribution) when the time came. We managed the exposure as “equity content” for asset allocation purposes.
The roads are littered with formerly well-performing companies/stocks that fell precipitously once hard times came thus decimating employees who held too much exposure. General Electric (GE) comes to mind being down -56% over the most recent five years after being up +38% over the previous five years!
The total return performance of VZ has not been inspiring over the past 10 years! As seen from the chart below, VZ has generated an average annualized total return of +4.9% compared to the S&P 500 (IVV) that was up +13.8%, a difference of 8.9%! VZ’s return is just a bit better than a core bond position (AGG) that produced +1.6% return over this time horizon, but at 4 times the risk! So this “equity content” performed like a bond with the “return per unit of risk” making this holding very suboptimal.
Fortunately, the VZ holdings were managed to a relatively small allocation so that its impact on my overall financial well-being was small. The rationale to hold the VZ shares to take advantage of the NUA benefit did not work out since the potential tax benefit did not exceed the potential after tax return of just holding the S&P 500 and paying an ordinary income tax on withdrawals. I had a reasonable rationale to hold an individual stock, but my stock-picking, though not a disaster, was inefficient.
D&A does not pick individual stocks for its clients, preferring instead to invest in broad baskets of securities. However, we believe there is nothing intrinsically wrong with holding individual stocks if a client desires it; just be certain to hold them in a diversified manner.