Ready For Retirement

Here's the Right Way to Determine How Much Individual Stock to Hold

August 08, 2023 James Conole, CFP®
Ready For Retirement
Here's the Right Way to Determine How Much Individual Stock to Hold
Show Notes Transcript Chapter Markers

How much of your portfolio is safe to hold in one individual stock? 

While 5% or 10% is typically recommended, rules of thumb like these are often irrelevant and harmful. The right answer depends upon your specific situation.

James explains the right way to determine how much individual stock you should hold based on your situation.

Questions Answered:
How much is okay to have in an individual stock?
What conditions make owning individual stock acceptable or unacceptable?

0:00 Intro
2:02 Monica's story
3:30 Individual stocks
5:02 Example 1
7:45 Conditions
10:18 Technicalities
12:37 Example 2
14:34 Emotional implications
16:11 Framework
19:43 Portfolio size
21:49 Time best spent
22:50 Underperforming
25:07 Why diversify?
27:01 Outro

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Speaker 1:

How much of your portfolio is safe to hold in one individual stock. Well, the general rule of thumb says 5% or 10%, but rules of thumb are often irrelevant at best and can even be harmful at worst. The right answer depends upon your specific situation, and we're going to cover that and more in today's episode of Ready for Retirement. This is another episode of Ready for Retirement. I'm your host, James Cannell, and I'm here to teach you how to get the most out of life with your money. And now on to the episode. One area where I would say my philosophy differs from that of a lot of other financial planners is many times a financial planner will say do not own individual stocks, or, if you do, keep it to 5% or less of your portfolio. And while I get the concept or the intention behind it, there's not just a blanket way or cookie cutter way to look at this and have any idea of saying your ability to hold individual stocks and the appropriateness of it in your portfolio is different than that of someone completely different. Now, there are parameters that you should follow, though. So when it comes to holding individual stock and making sure you do so while also having a firmly established and well-defined plan. It depends on your situation, and so in today's episode I'm going to cover that, but before we do, I want to quickly highlight the review of the week. This week's review comes from username marker V and it says five star the best financial planning podcast. Straight show, straight talk, understandable and practical, pragmatic information to help plan for enjoyable life in retirement. Marker V, thank you very much for that review. I appreciate all of you who are taking the time to do so. I read them all, I get them all. That's important feedback for me, but, most importantly, it helps more people to find this show. So, if this has been helpful to you, if any of this content has, I'd appreciate it if you would share this podcast with friends, with family, with coworkers, and also take a few minutes or a couple of minutes or 30 seconds to leave a review, if you're so inclined. So thank you for all of you who have done that. And now let's get on to the show. So I love all my clients, of course, but one of my favorite clients we're going to call her Monica and it's with her permission to share in this story but she brought up an interesting, or she made an interesting comment. I should say a couple of weeks back when we were meeting together. So Monica has always been a good savior, a good investor, and she's worked at Apple. She just recently retired, but she worked at Apple for 20 plus years before retiring. And she brought up the comment. She said gosh, I feel so good now with the plan that we have. How much better would things have been had we started doing this, say, 20 plus years ago, back when I had questions about what to do with 401k and how much stock is okay to have in company stock, and so it got us to thinking and got us to talking about okay, how much should a specific person have an individual stock? And so I mentioned a couple of things to her. But number one well, monica, I started doing this 12 years ago, so unfortunately would not have been around 20 years ago to be doing this type of thing. But number two, assuming I had been, I'm not so sure Well, I'm almost convinced that your returns would not have been as good as they were over those 20 plus years, simply because you had a good chunk of your money in Apple stock. And it's no secret that Apple stock has done incredibly well over the past 20 plus years. So, as we get to thinking about this, or having this conversation is bringing us an interesting points of given your specific situation whether it's with 401ks or Roth accounts or brokerage accounts or stock compensation or just individual stocks what should that look like? How much is okay to have an individual stock? How much can contribute to your plan versus at what point does it potentially detract from your plan and even become dangerous? And here's the thing about individual stock. When people come to me and say, james, how much stock is okay to have in a plan, there's this sense of we want a precise answer, as if it depends upon the specific stock. So, for example, if it's an IKIE stock, you can hold this percent, but if it's Tesla stock, that percent, or whatever the case might be, because the thinking is oh, this company stable, this company pays dividends, this company has been around 100 plus years versus that company. Well, that company is kind of a wild card and maybe it goes off and goes crazy, but maybe it goes out of business. And, yes, there is some small degree of truth in that. But the reality is, all stocks are risky. You can't point to a single stock and say there is no risk in this company. Yes, you can point to some companies and say, hey, this company's probably going to be around for another 30, 40, 50 years. That could be the case, no-transcript, and the company still dramatically underperforms the market. So the first thing to recognize is it does not matter the specific stock you're looking at. Every single individual stock carries a significant amount of risk in it. That's the nature of investing in equity in companies and stocks. Another thing to note before we dive into the specifics here and this is stating the obvious, but I think sometimes the obvious needs to be stated, otherwise we can unintentionally start to make wrong assumptions about stock returns. But this answer would obviously be very different if we knew exactly which stocks were going to outperform. For example, in Monica's case, she held a lot of Apple because she worked at Apple for a long time. That turned out to be the right decision. So if 20 years ago I could have gone back in time and known exactly what was going to happen with Apple, I would say do not dare diversify the stock. This stock is going to be incredible. You should keep it in the same way. With the benefit of hindsight, I know what the winning lottery numbers were. So if I had gone back to the person who bought the winning lottery ticket, I would have said absolutely, buy that ticket. I know, because of the benefit of hindsight, that this is going to be a winner. However, today, looking forward, I have no idea what the next lottery numbers are going to be. So if you came to me and said, james, should I buy a lottery ticket, I would say absolutely not. That's not a wise use of your money because I don't know the future, but I do know the odds of you picking the winning lottery ticket are very small. So when we're looking at individual stocks and I know this is stating the obvious you might be saying James, get on with it. But it's so important because when it's our company we're investing in, or the company that we work for or has a long track record of superior returns, it's very easy to fall into the trap of thinking that's going to continue. Well, if that was going to continue if Apple stock, for example, is going to do over the next 20 years Apple stocked it over the last 20 years I would say there's no reason to own any other investment in your portfolio other than that. Obviously a disclaimer. That's not a recommendation. This is just an illustration. But if that was the case, and it was that easy, diversification is kind of dumb. Why would we accept lower returns? Well, we accept market returns because we don't know what the return of an individual stock is going to be and more on this later. The average return of the average individual stock is actually less than the average return of the market as a whole. So if Monique, for example, hadn't worked for Apple for the last 20 years, but she had worked for the company that Apple displaced Blackberry, her financial situation would be wildly different, because Blackberry stock had the opposite experience of Apple stock. So in retrospect it seems obvious which stocks were going to be the winners. But going forward and looking forward, it's impossible to know over the next 30, 40, 50 years what is going to do best. So, as we're having this conversation, I don't care if it's Apple stock, that you have AT&T stock, visa stock or something entirely different. It depends less on the individual stock and more on your specific situation, because in some cases the right percentage to own an individual stock is exactly 0% and if you own any, it starts to potentially be harmful to your situation versus in others, you could make a case for having the majority of your portfolio in an individual stock and still be okay. So what we need to look at is what are the conditions that would make owning individual stock acceptable or unacceptable, and to what extent would it be acceptable given the overall portfolio that you have and the goals you're trying to do? So here's an example of how this could be the case. Let's assume that you have two people. Now both of these people come to you and they say I want $50,000 per year for my portfolio. How much can I have an individual stock? Well, you might be tempted to say well, they're the same person, but just duplicated same age, let's say same needs from their portfolio. Should they therefore have the same capacity to own individual stock? Well, not necessarily. It all comes down to their portfolio value. Let's assume person number one has a million dollars in their portfolio. In person number two has five million dollars in their portfolio. Well, what you need to do is you need to work backwards. We know that both of these individuals need $50,000 per year from their portfolio. How much portfolio or what portfolio size is required to make that happen? Well, this, of course, is where you want to understand. What withdrawal rate are you going to use and how are you going to diversify your portfolio in a way to support that? But let's assume that your portfolio, based on the way it's diversified in your age and time horizon, it can support a 5% per year withdrawal rate. Okay, to get $50,000 per year, you would need $1 million, because 5% of a million dollars is at $50,000 per year. So how much can person one afford to have in stocks? I'd argue 0%, or at least very, very little. Because any individual stock has the potential to go the way of Blackberry, to go the way of Silicon Valley Bank, to go the way of Enron, to go the way of many of these companies that have had disastrous returns or even outright gone bankrupt. So if you take a million dollar portfolio and put 10% of it in an individual stock and that individual stock performs horribly, the implications of that are you really only have 900,000 left, or 900,000 plus whatever small amount is left in that stock. The implications of that are your spending has to change. So if it's an unacceptable outcome for you to have to reduce your spending down from 50,000 per year, then it's unacceptable, in my opinion, to hold any degree of risk in there to that, to hold any degree of risk that your spending would have to be cut because of the bad performance of a single company. Now, there are some technicalities around this. So I did say, hey, I don't care what stock you own, all stocks carry an inherent degree of risk. There is truth to that. But there's also truth to this. If you look at the market as a whole, so the S&P 500, in this case, the largest 505 or so companies in the US Well, if you look at Apple, which is the largest of the holdings, so the S&P 500 is what's called a market cap weighted, so the largest of those companies is going to represent a greater percentage of the S&P 500 than is the smallest of the companies. Well, apple, as of this recording, is the largest company. It makes up 7.5% of the S&P 500. That's a pretty significant allocation of the S&P 500 to one single company and that's just due to, of course, apple's large size Versus. Today, as of this recording, the 500th company in the S&P 500 is Lincoln National Corporation. Lincoln National makes up 0.01% of the S&P 500. So you could absolutely make the argument that, look, if I'm owning one of the top five or top 10 or top 15, whatever you're looking at companies in the S&P, could I get away with owning more of that? You could get away with that from the standpoint of it's not deviating that significantly from the rest of the market. If I own 5% in Apple and have the rest of my portfolio offsetting that, that might be not too different than what Apple makes up in the market as a whole, versus if I own 5% of my portfolio in Lincoln National Corporation. This is neither an endorsement for or against this specific stock. But now all of a sudden, I'm significantly skewed in terms of my weighting to each of the companies or each of the stocks that whatever index or fund or asset class I'm trying to hold represents. So you can make some distinction within that. But in general, I would look at it from the standpoint of if I have a million dollars in this example and I can't afford to lose any of it via an individual stock going out of business, well, I need that full million dollars to be diversified. Hey, everyone, it's me again for the Disclaimer. Please be smart about this. Before doing anything, please be sure to consult with your tax planner or financial planner. Nothing in this podcast should be construed as investment, tax, legal or other financial advice. It is for informational purposes only. Now let's take a look at individual number two. As we've already established, individual number two also needs $50,000 per year. We can therefore infer the individual number two also needs at least a million dollars, diversified in such a way that it can support that $50,000 per year. However, individual number two doesn't have $1 million to make this happen. Individual number two has $5 million to make this happen. So, to keep it super simple, you could say $1 million of that, $5 million needs to be diversified because that's the portion of the portfolio that's going to cover your needs. If you want to take a simple needs analysis perspective, well, the excess $4 million under this perspective is technically that it's excess. So how much of it could you afford to invest in a single stock? Well, technically, I'd argue you could afford to invest 100% of it into an individual stock, because you always have to look at worst case scenario. Assume that $4 million was invested into Silicon Valley Bank. Well, bummer, you just lost 80% of your entire portfolio. You lost 100% of your stock, but that stock represented 80% of your overall portfolio. But you're still technically okay from the standpoint that you have $50,000 per year that you can still create from your remaining portfolio balance. Now, just because you're okay financially does not mean that, in reality, you would be okay. You would be pretty darn upset if your $5 million portfolio turned to $1 million over a very short period of time because you invested 80% of your stock into a single stock that went bankrupt. Now let's take a big step back. Are the odds high that you're going to put all your money into an individual stock that's going to go bankrupt? Statistically speaking, no, the odds are not high. However, that is a risk, and doesn't even need to be a full bankruptcy for this to derail your plan. If you're dependent upon the individual stock, even just underperformance can be disastrous, depending upon how you're structuring this. But the other side to this is the emotional side. As we just established, if you do a simple needs analysis and you have $5 million in this portfolio, you only need to diversify $1 million, which means, technically, you could allocate the remaining $4 million to an individual stock. It doesn't mean it's the wisest, but technically you could afford to financially. What you have to ask yourself, though, is emotionally, are you actually going to be okay Even if the stock's not going down? Are you going to be okay. Most people just think about it from the standpoint of okay, if I invest in an individual stock and the individual stock is going down quite a bit, that's when it's causing some emotional distress. But it's also the opposite. Now, when stocks are going up, yes, that's bringing a lot of I won't call it joy, but maybe a big degree of dopamine is being released and it's creating some extreme excitement. But even that can become all-consuming and it can become almost as addictive behavior as, as you have a lot of money in an individual stock, those daily swings, even if they're trending upward, can start to take a toll on your emotional health. I've seen this time and time again. So don't just think of it from the standpoint of owning an individual stock is only bad. In the case of the stock does terribly. It can also be harmful emotionally, even if it's going up, because any stock is going to deviate significantly even on the way up, and it can become this all-consuming thing if we're not careful about how we personally are going to receive whatever's happening with that stock. So a couple more things I want to touch on that I think are important with regards to this discussion. One is just a basic framework to follow. If you're asking yourself this question, here's what I would start with. Number one do the needs analysis. Understand what level of income you need your portfolio to support. Now, this could be basic things like basic living expenses and retirement. This could be things like home down payment. This could be things like sending kids to college. But number one start with what's needed from my portfolio no-transcript Determining the portfolio size needed to make that happen. So in our very basic example, if we go back to individual one and two, maybe I should have given them names, but just individual one and two. Step one for them understanding how much they need, that would be the $50,000 in their case, they would go through an exercise to say, okay, I need $50,000 per year. Number two in determining the portfolio size needed to make that happen, both of their answers would have been $1 million and though they both had different portfolio sizes, they both would have had the same portfolio size needed to make their income needs happen. And then step number three. That's where I would say determine what you want to do with the excess and why. So for this step, individual number one didn't really have any excess. They would really need to make sure their full million dollars was fully diversified to be able to support their income needs. Individual number two however, they did have excess. They had a $4 million of excess. Now, just because it's quote unquote excess doesn't mean that you should be flippant or unwise with it. You should absolutely still seek to do the best you can with that, whether you technically need it or not. But that's where you have more leeway. If there is an individual stock that you want to hold or if there are some unique things you want to do with it, that's the amount that you can afford to do something with, because even if it doesn't go according to plan, it's not as if your financial strategy or your personal situation is in serious jeopardy. So, as we're talking about this, some of you might be thinking do people really wrestle with this? Do people really own a whole bunch of individual stock? Yes and no. Where I see this most commonly is with executives or people who have some type of stock compensation plan. So you have your base salary and your bonus and you're using that to put money into 401Ks and to save and to do your diversifying. But you also, depending upon your position with the company, might have some pretty serious equity in your company. So this is what a lot of people want to know, whether they have restricted stock units. So RSUs or stock options or incentive stock options or an employee stock purchase plan. There's all these types of different stock compensation and the question always comes down to how much should I keep in that plan versus how much should I diversify? So this is where I see this most commonly and for a lot of people it can be kind of fun to own stock in your own company. It can be very fun. But also keep in mind the counterpoint to that. As I mentioned, when you have a lot of your net worth tied up in one individual company, the swings can take a toll on your emotional health, even if those swings on average are trending upward. So be cognizant of you and your own personality of what makes most sense. But I have many clients who are executives at different corporations and they do have a fairly significant portion of their net worth in a single company stock and now some of these stocks have outperformed the rest of the market. They've been very glad they've done that. Other clients their stocks have underperformed the market. However, in all situations what we did first and foremost is we went through that basic framework. What do we need from our portfolio in the future? Step one. Step two what portfolio size do we need to be able to accomplish that? Once we've done that, then step three is that what do we do with a quote unquote excess, which in many cases not always, but in many cases is what that stock compensation represents? So assuming you have your 401ks and brokerage accounts and other assets positioned in a way that even if that stock went to zero or significantly underperformed, you would still be okay, then there's not necessarily a limit on how much you can own, and do so safely, in an individual stock. That's really not a guarantee that being diversified elsewhere is somehow going to cause your stock that you own to miraculously outperform. But what it is saying is, even if that stock doesn't do well, you're going to be in a position to where you can buffer it. You can absorb that and not have it impact your personal situation. Now last part here a lot of people ask me James, what about you? What do you personally do? Now? Number one just because I do something doesn't necessarily mean it's the best thing in the world to do. But number two I think the important thing to know and I tell us to my clients, is I eat my own cooking. I actually don't own any individual stocks Now. I have before, but I've since sold them. But I ask myself three questions if I'm going to invest my money somewhere, whether it's a stock or anything else, just a basic framework. Number one is do I enjoy this Now picking individual stocks? Yeah, it's kind of fun, I would say I enjoyed it. Now, do I enjoy it more than work? Or do I enjoy it more than the other things I like to do outside of work, with friends or with family? No, I don't enjoy it more than that. So when I'm looking at this, is this where I want to spend my time? Or do I get more satisfaction out of the work I do with clients and the things I do with friends and family elsewhere? Well, it's the latter. So number one in my framework of it's not something I enjoy doing more than the other aspects of my life. Now, that's not a be-all-and-all, because there's some things I don't enjoy doing, but they're very meaningful or they're very necessary to the fulfillment of my goals, but that's at least number one. Do I enjoy it more than the other things I spend time on? And for me the answer is no. The second question you have to ask is is this where my time is best spent? What's the return on investment of my time? So, as you're looking at picking individual stocks, what time is that consuming, both financially? So to me, financially, is my time better spent picking individual stocks from me personally, my personal portfolio, or is it growing a business and improving a business and working with clients? I'd argue, I'd just argue, I'd say definitively that my greatest return on investment is working within the business and working on the things that I can control. And then, even relationally, where do I want to invest my time? The return on investment I get spending time with my wife or my daughter or my friends, significantly greater in my mind than any potential return on investment with stocks. And then number three brings us all together, because some people might be saying well, James, if you could do better because you enjoyed it or you did enjoy spending time there, wouldn't you do it? Well, if I enjoyed it and if it was where my time was best spent and I could outperform, then absolutely would be a no-brainer. But the third point is am I okay with underperforming? If I'm going to own individual stocks, I have to be okay with underperforming. Jp Morgan put out a great study and what it showed is that if you look at the Wilshire 3000, which is pretty much I think it's 98 or 99% of all the publicly traded stocks in the United States going back to 1970, two thirds of those stocks in the Wilshire 3000 underperformed the Wilshire 3000 itself. Well, how could that be? But what happens with stock returns is there's a handful call it 5%, maybe even up to 10% of individual stocks whose performance is so good that it pulls the rest of the market along with it. However, what that means is the other 90 to 95% of stocks aren't going to do as well and in fact, 67% or two thirds of stocks are actually going to underperform the market as a whole. So when you're picking an individual stock, understand the odds are against you. The odds are against you that you actually outperform the rest of the market in doing so. Now you can say, well, it's obvious what stocks are going to outperform the market, but you're only saying that because of what's happened over the last five, 10, 15 plus years. We can look back now on Tesla or on Apple or on Microsoft or on Nvidia and say, oh my gosh. Of course this was going to happen, but that wasn't the case 10 years ago, 15 years ago. 20 years ago, some of those companies weren't even around at that time. Now look at this the best performing stocks of the 2000s. Who would have guessed that Domino's would have been one of the best performing stocks? Or Monster Energy? Or Netflix? Go back to the beginning of 2000,. These weren't the companies that were top of mind. So the next 20 years, 30 years, what are the odds of you picking stocks that will outperform the rest of the market? Well, that would say pretty low, and not just you, not just me, but even Wall Street. If you look at people on Wall Street and say, hey, what are the best performing stocks going to be, or where's the S&P 500 going to end up this year? Almost always they are wrong. The good news is, you don't need to be right to have success. You just need to make sure you're properly allocated to the entirety of the market, or maybe not the entirety of the market, but the certain aspects of the market that you specifically need to capture when you're looking at your financial plan. So what's the real reason? I diversified the biggest reason? I want to perform the best I possibly can. I want to grow my money the best I possibly can. And too often people look at diversification and say, okay, that's what you do, if you're okay with accepting mediocre returns. No, that's what you do if you want to maximize returns. If you want a greater chance of underperforming, then that's where you pick individual stocks and again a good number of people will outperform the market. But I would argue it's by sheer luck. Most of the time. You have as I mentioned before you have to be right a two out of three chance you'll underperform the market by picking an individual stock. Then you will outperform the market. So that's my basic framework. And then, even when I'm investing, I'm not just buying one single index fund. I'm making sure I'm broadly diversified in picking the type of asset classes that are going to deliver at least, historically speaking, have delivered the highest potential return for a given level of risk I'm comfortable with, based upon different investment goals. So that's me, that's my framework, not saying that everyone has to do it, but I do think it's important that people understand what I'm saying. Something it's not something that this is what you should do, but I'm going to do this because here's where the superior returns are. So that's a basic framework for how to think about owning individual stocks. Are individual stocks bad? No, can you be just fine even if a significant part of your portfolio is an individual stocks? Yes, heck, you could even be like Monica, who did incredibly well because her individual stock happened to be one of the best performing companies of all time. However, there's no guarantee going forward of that company continuing to perform that way, or any company performing a specific way. So have a plan, understand what your portfolio needs are, understand what portion of your portfolio needs to be diversified and understand what you want to do with the remaining portion, both from a financial standpoint and an emotional standpoint, of understanding what you'd be comfortable with. So I hope that is helpful. Thank you, as always, for listening. If you have not already done so, be sure to leave a review. Also, if you've not already done so, please be sure to subscribe to our YouTube channel. It's called Root Financial. You'll find this podcast. You'll find other videos that are released every single week to make sure that you're getting the most out of life with your money. Thanks for listening and I'll see you next time. Thank you for listening to another episode of the Ready for Attignment podcast. If you want to see how Root Financial can help you implement the techniques I discussed in this podcast, then go to RootFinancialPartnerscom and click Start here, where you can schedule a call to one of our advisors. We work with clients all over the country and we love the opportunity to speak with you about your goals and how we might be able to help. And please remember, nothing we discuss in this podcast is intended to serve as advice. You should always consult a financial, legal or tax professional who's familiar with your unique circumstances before making any financial decisions.

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