Photo: Alan Murray-Rust. Source: Geograph
That’s the challenge that a lot of investors are facing. Facebook and Amazon and the other growth darlings have done so well for so long that they now represent an oversized position in many portfolios. It’s a simple matter of mathematics: If a holding in a 20-stock portfolio doubles in a single year while the rest of the portfolio remains stable, it’s weighting in the portfolio roughly doubles. If that happens a few more years, that stock can grow to become 20% or even 30% of your holdings. What do you do?
The temptation is to do nothing. That growing company has been carrying your portfolio forward. As it grows in importance, its excess return becomes a bigger part of your total return. As it does well, your portfolio prospers. Also, doing something carries a cost. Anytime you sell a position you incur transaction costs – broker commissions and the spread between bid and offer price. Also, for taxable portfolios, taking gains incurs capital gains taxes – 15% to 20%, for most folks.
But a problem comes from doing nothing. As an equity grows in importance, your portfolio’s performance comes to look like that stock’s performance. That’s fine when the company is doing well, but when trouble hits, your portfolio could be in trouble, too. We own diversified portfolios because they’re less risky than individual holdings. If you let a single security take over your portfolio – for all its benefits – your fortunes rise and fall with that one position.
A diversified portfolio and individual stocks. Getting there is definitely not half the fun. Source: Bloomberg.
That’s what people are finding out now with Facebook. Facebook went public six years ago and has grown at roughly double the rate of the general market. A 5% position at the start is now a 10% position in most portfolios. That’s great when the company is doing great, but can give investors heartburn when Zuckerberg and Co. face challenges.
Disciplined portfolio management means trimming positions when they grow to dominate your holdings, even if that means paying some taxes and lagging the market for a while, if the winners keep on winning. Because trees don’t grow to heaven and – inevitably – the limits to growth will kick in. Although it’s often tough to tell when that will be.
Douglas R. Tengdin, CFA