Journal of Financial Planning: August 2017
Robert A. Clarfeld, CPA, CFP®, is founder and CEO of Clarfeld Financial Advisors, a wealth management firm and multi-family office founded in 1981 and now with over $6 billion in AUM that provides comprehensive financial planning and investment management services.
Senior corporate executives are a large segment of our firm’s practice. As such, the merit of diversifying portfolios highly concentrated in company stock is a frequent discussion. Generally, the concentration builds over many years due to stock bonuses, deferred compensation, stock options, restricted stock grants, other corporate asset accumulation plans, and occasional market purchases. Sometimes companies mandate that senior executives hold a certain amount of stock, perhaps as a percentage of compensation. Even when this is a consideration, most executives have difficulty diversifying holdings beyond policy requirements.
In the field of portfolio management, much has been written on the generally unfavorable risk/reward metrics of overly concentrated portfolios, especially when the concentration is in a single security. Most of our executive clients acknowledge that their portfolios are exposed to unsystematic market risks and readily agree that if they were counseling clients, they would recommend diversification.
So why do executives find it so difficult to diversify? The answer lies outside of the realm of modern portfolio theory.
Most of us have complicated relationships with our finances. When these financial complexities overlap with employment and career aspirations, even the most financially savvy executive can lose perspective.
We do not always behave as rationally as traditional economic theory, including modern portfolio theory, would suggest. We all have biases that cause us to react to situations differently than economists would predict. Many reasons we act irrationally have been studied extensively in behavioral finance, which, in part, studies various cognitive and emotional biases. Many non-rational biases can contribute to why executives often highly concentrate their wealth in their company’s stock. The bias that we find most prevalent is the endowment effect.
Understanding the Endowment Effect
In 1980, Richard Thaler coined the term “endowment effect” noting that people often demand much more to give up an object than they would be willing to pay to acquire it. The behavioral finance literature has many studies concluding that we overvalue that which is already owned. Returning to our corporate executive clients, it is common that they often believe that the price at which they would be comfortable selling their company stock is greater than the price that the marketplace offers; leading to the belief their stock is undervalued.
The world of finance is rife with data that can support almost any point of view. Finding reasons to justify a wide range of valuations for a given asset isn’t difficult; one can argue that most companies have tangible and intangible attributes that aren’t adequately priced into its stock.
We often ask an executive: “If you did not already own or have a contractual requirement to hold a particular stock, based on its merits, would you buy it at the current price?” Although we realize hypotheticals are not going to provide unbiased responses, we find that asking the executive to indulge in abstracts can be helpful.
An important aspect of investing, especially when constructing an asset allocation, is one’s personal comfort with various asset classes and specific investments. Clearly, clients are quite knowledgeable about their employer and industry, and it is human nature that familiarity and comfort with any type of investment often leads to a sense of safety. Conversely, investing in anything other than that which is most familiar rarely feels safe.
Often our recommendation to diversify from the “safety” of company stock is met with resistance: “Why isn’t my employer a great investment?” We try to keep the discussion that follows focused on various types of portfolio risk and the concept of diversification, rather than company specifics. These are difficult discussions that rarely break new ground.
The endowment effect is not limited to company stock. Generally, any asset long-held, perhaps inherited, is viewed by individuals as undervalued relative to the marketplace. Unlike most assets where the concentration remains static, save for market fluctuations, the impact of the endowment effect on concentration in company stock increases as the executive accumulates additional shares.
Evolving over Time
Generally, risks associated with a highly concentrated portfolio exacerbate over time—usually from the confluence of additional stock grants and fewer remaining working years to replace lost capital. Periodically, one’s asset allocation should be updated, and over time, portfolios should become more conservative. This is especially true as it relates to unsystematic risk, and a portfolio that is highly concentrated in a single security, or even a single asset class represents an unacceptable unsystematic risk.
When one is within single-digit years of anticipated retirement, an overall plan for diversification becomes even more important. Early in one’s career, when stocks decline there often are new stock option grants that reflect the lower price, resulting in a greater number of shares, essentially an averaging down process. In retirement, there are no additional grants and selling when prices decline becomes even more difficult.
Other Biases Influencing Willingness to Remain Concentrated
Behavioral finance addresses different cognitive and emotional biases that likely contribute to an investor’s determination to remain concentrated in company stock. As with all psychological factors, there are many behavioral components to why we act as we do. The following are a sampling of investors’ biases.
Anchoring bias. Investors have a tendency to be “anchored” to an initial mindset regarding the value of an asset, and to ignore new data. It is common for the investor to hold on to this initial stock price or forecast, remain fixated on this price, and not be open to new developments surrounding the company, industry, or market environment. Say an executive has developed an expectation as to the price or growth of their company’s stock, and the stock declines or doesn’t appreciate to meet expectations. Although one may hold the belief that the stock should recover (and then some), the marketplace is indifferent to one’s initial price expectation.
Overconfidence bias. Investors exhibit exaggerated confidence in their ability to judge the merits of a stock, especially if they are instrumental in managing the company. Senior executives often believe they have superior insights discerning relevant data and news flow specific to the company’s competitive position, further fueling their resistance to diversifying.
Loss aversion. Investors react differently to losses and gains of the same magnitude, and as a result, their attitude toward both absolute and relative risk is altered by an aversion to realizing portfolio losses. Essentially, losses tend to inflict far greater pain than the pleasure that similar gains provide. As such, executives may tend to avoid selling their stock when it is down to avoid the recognition of a loss. Sometimes, investors purchase additional shares at declining prices in an effort to lower their break-even price. By “trying to catch a falling knife,” small losses can easily become huge.
The behavioral aspects behind remaining highly concentrated in company stock are complicated. At our firm, we use a systematic process to support our arguments for diversification:
Consider consulting research as to how the marketplace values the company and its industry. Executives often know a great deal about their own company, as well as other companies in their industry, but in a very different way than industry analysts. I’ve heard it said that “the dumbest guys running valuation models at major investment houses know more about how the market values a company than its CEO.” No doubt an exaggeration, but perhaps an exaggeration with some merit.
Volumes of research show the various types of financial risks associated with highly concentrated portfolios. The conclusions are consistent: unsystematic risk is rarely rewarded when compared to diversified portfolios. Like virtue, diversification is its own reward.
A strategic asset allocation model creates a portfolio blueprint based on long-term goals and objectives. The asset allocation should be derived from one’s financial planning, not the reverse. Although asset allocations can change over time, the discipline of adhering to this financial model should be constant.
Portfolio management is an important aspect of one’s overall financial plan, but it is not the entire focus. It is essential to periodically revisit one’s long-term financial plan to maintain an overall perspective. Consider the required cash flow necessary to fund retirement and how these funds will be generated. After the requisite asset base has been achieved, with a healthy cushion, one’s risk/reward curve changes. It is extremely important to recognize the need to adjust one’s portfolio to reflect the dynamic risk/reward utility curve.
Personal factors may also contribute to a high concentration in one’s company stock. Perhaps an open discussion with friends, family, and professionals can help create greater awareness of non-financial contributing factors.
It is difficult to be objective about a stock we already own, issued by the company that employs us. Owning company stock is a wonderful affirmation of success; and some degree of concentration is common.
Questioning whether the endowment effect is playing a major role in the decision to remain concentrated is a worthwhile exercise for the savvy corporate executive.
The author thanks Michael Hans, CFA, and Matthew Ruffalo, CFA, for their assistance.