One of the most coveted Wall Street darlings in history emerged in the 1990s and rose to meteoric heights. This firm had a reputation for hiring the best talent, outmaneuvering competition, and making shareholders a lot of money.
Management paid huge bonuses to top producers, which were often in the form of company stock. Since the stock price surged over so many years, employees gleefully watched their net worth skyrocket. Many employees became multimillionaires well before their 30th birthday.
Incredible wealth understandably creates an emotional attachment to the investment responsible for such a life-changing event, and the bond between investors and this stock only strengthened over time due to three influential forces:
- Management: Executives urged employees to buy as much company stock as they could afford because the prospects were so bright. Employees were also hesitant to send any signal to their bosses that they would ever doubt management’s bullish tone.
- Proximity: Employees often prefer to own their employer’s stock because they believe that they have an “edge” over other investors, since they are closer to the day-to-day operations.
- Wall Street: Analysts from the largest banks, who were paid millions every year for their recommendations, were in near unanimous agreement that this stock had to be owned for the long run.
Given this backdrop, it’s hard to blame employees for refusing to sell a single share, and those who remained invested enjoyed the spectacular ride depicted in the chart below.
Performance like this often acts like a powerful drug on shareholders’ psyche. Each tick higher becomes the next dopamine hit, fueling an addiction that blinds them from the dangers associated with permitting a single stock to dominate the bulk of their net worth.
Unfortunately, this company’s name was Enron, and the chart below illustrates how billions in wealth disappeared in weeks, as the world learned that management had been committing fraud.
Still to this day, questions remain about how so many smart people lost so much money and why they did not see the fraud sooner. But it’s hard to blame shareholders for failing to see fraudulent activity. Fraud is extremely rare and often conducted by a small group of bad actors out of reach from most employees and regulators. Where they do bear responsibility is putting all their eggs into one basket.
No matter how much conviction one may have about an investment opportunity, diversification demands prudence. Building net worth is a process of managing risk, and a critical step is eliminating the unnecessary ones along the way.
Each investor is unique, so it’s tough to generalize about when the concentration becomes too high. But I cannot think of a situation when a single investment should ever comprise more than 20% of investable assets (excluding a primary residence).
Simply put, Enron shareholders may have lost their investment due to fraud, but those who watched their net worth vanish in the blink of an eye have no one to blame but themselves.
The Bottom Line
Alfred Lord Tennyson once said, "'tis better to have loved and lost than never to have loved at all." While that may be true for love, I don’t think it applies to wealth. I’m pretty sure that acquiring tremendous wealth and then losing it is a lot worse than never having it at all. Especially when the risk of loss can be so easily avoided.
Stocks get handed down through generations, some take investors from rags to riches, and others represent an entrepreneur’s life achievement. In each of these scenarios, emotional attachments understandably develop toward a stock in the form of loyalty, pride, and gratitude.
However, emotions are viruses waiting to attack a portfolio, and any love and/or admiration for an investment will be a one-way street. I have lost count of the number of times a once wealthy investor watched their net worth vanish because they could not break some misguided emotional bond to an investment.
Admittedly, there are instances when an investor must maintain a concentrated position. For example, executives are often required to hold stock for a minimum amount of time, while others fear that selling stock could signal to the public that prospects for the firm are dire. Fortunately, strategies exist for those who cannot sell but still want to mitigate the risk of a concentrated holding. If you find yourself in this position, talk to your financial advisor.
And to the YOLO apes (the “You Only Live Once” traders that refer to themselves as apes for reasons yet to be explained) who bought meme stocks and continue to brag about how their “diamond hands” (refusal to sell) have made them overnight millionaires, my advice is simple. Trim those positions asap.
You won and all those old school investors (like me) who told you repeatedly that you’ll get what you deserve look like fools now. So, count your winnings, take your victory lap, and diversify your portfolio today. Otherwise, you risk having to live in your parent’s basement for a lot longer than you may realize.
The bottom line is that breaking up is hard to do, but it’s nothing compared to the pain and mental anguish of watching your net worth get eviscerated because an investment didn’t love you back.
This material has been prepared for informational purposes only and should not be construed as a solicitation to effect, or attempt to effect, either transactions in securities or the rendering of personalized investment advice. This material is not intended to provide, and should not be relied on for tax, legal, investment, accounting, or other financial advice. Richard W. Paul & Associates does not provide tax, legal, investment, or accounting advice. You should consult your own tax, legal, financial, and accounting advisors before engaging in any transaction. Asset allocation and diversification do not guarantee a profit or protect against a loss. All references to potential future developments or outcomes are strictly the views and opinions of Richard W. Paul & Associates and in no way promise, guarantee, or seek to predict with any certainty what may or may not occur in various economies and investment markets. Past performance is not necessarily indicative of future performance