Academic work by leading market researchers like Nobel Laureates Eugene Fama and Harry Markowitz leads us to warn investors that portfolios holding concentrated positions in a few big stocks are a risky way to manage wealth.

Still, investors often come to us with oversized weightings in individual names. At other times, some clients will ask their IFA wealth advisors to buy shares of select companies they might feel particularly bullish and/or emotional about.

Either way, our recommendations are unwavering on this issue. Letting a single stock take a large position actually has the effect of constraining our wealth management team from designing fund portfolios to maximize expected returns in the most risk-appropriate fashion.

Simply put, building and maintaining a globally diversified indexing strategy around a few concentrated names creates a myriad of different investment problems.

For one, holding a large stock position can skew overall portfolio performance in terms of trying to monitor and benchmark returns over different periods. This acts to cloud IFA's evidence-based portfolio allocation and diversification strategies, all of which are aimed at maximizing expected returns according to each client's risk capacity. 

Consider the chart below. It compares returns and standard deviation, a common measure of risk, for the 208 publicly traded stocks that have been listed on the New York Stock Exchange going back to 1976. As displayed in this graphic, if you owned individual companies on the NYSE then you were essentially penalized by the amount of return you received relative to the amount of risk taken. 

You can also toggle to view the 52 survivors over that 40-plus year timeframe covered by the tech-heavy IFA NSDQ Index. (Click on the "AAPL" button in the bottom right corner to bring up a chart of both groups.) 

These benchmark comparisons are graphed against different IFA Index Portfolios. Also shown are broader IFA indexes covering various asset classes such as U.S. small-cap value, emerging markets and global real estate. Hover over each dot and you'll see annual returns and risk metrics.

The clear takeaway here is: When stacked against a globally diversified portfolio with thousands of different holdings, the chance of picking a single outperforming stock is slim. At the same time, notice how individual names in the NYSE and NSDQ cluster to the right side of the chart -- an illustration of how much greater the amount of market risk these concentrated positions inject into the investment picture. 

Concentrating risk in a few big names can raise a wide range of debilitating issues for your investment portfolio. Some of these harmful effects include:

Inducing a greater amount of 'recency bias' into a portfolio. Along these same lines, typically when people own individual stocks, we've found that they tend to ask us about U.S. blue-chip names, particularly shares of large-cap growth companies. These are often ones that have done well recently, inducing another red flag into the investment process.

Financial behavioral scientists refer to it as 'recency bias,' and caution that investors too frequently make portfolio decisions based on the latest hot performers. As you can see from the chart below, chasing performance through individual stocks is a losing proposition.

By its very nature, concentration results in narrowing your chances of success to a sliver of the market's potential source for greater returns. Not only should you guard against chasing returns and hoping the same names will keep leading markets higher, but you need to also be wary of any advice to become too focused on any one part of the market.

In the case of those who hold big positions in a few blue-chip names, or ask us to add shares of a stock they know about and recently has done well, a point to keep in mind is that historically large-cap growth has proven to be a laggard relative to a more diversified portfolio of index funds tilted to value-style and small-cap stocks. So has small-cap growth, at least over the past 50-odd years. Both are areas we get asked about on occasion, given that 'growth' in any size has a tendency to capture today's biggest headlines. (See chart below.)

Portfolio overlap and redundant holdings. A traditional IFA Index Portfolio holds more than 13,000 stocks covering 40-plus countries. For example, holding shares of Microsoft, Facebook, Apple, Amazon, Netflix and Google (i.e., Alphabet) might sound like a good idea. If you're investing in an IFA Index Portfolio, though, you already own shares of these companies. 

Doubling up on individual positions creates redundancies that work against a finely tuned portfolio. The science behind our fund allocation process already takes into account differing risk and return characteristics between various asset classes. Domestic large-cap value and emerging markets stocks, for instance, present different performance and standard deviation profiles. So, although your intention might be to emphasize a favorite company, even the slightest overlap can make an IFA Index Portfolio less efficient.

Letting taxes wag the investment tail, so to speak. If the reason why you kept these individual stocks was out of concern about capital gains taxes, then ask your IFA wealth advisor to run what we call a portfolio "Gains/Loss Report." Such an analysis is used to check a fund or security's capital gains and capital losses status. The purpose of this report could be to identify opportunities to sell highly appreciated positions and liquidate positions at a loss to offset the tax losses of any gains.

To better understand the advantages of diversifying an investment portfolio and minimizing any concentration risks, we suggest you talk to an IFA advisor before actually putting such practices into motion. Among other resources, your trusted wealth advisor can tap into the expertise of Lisa Rimke, who heads IFA Taxes. An experienced certified public accountant (CPA), she's trained to work in tandem with each client's advisor in developing investment strategies to fit each person's unique financial and tax situation. You can reach her at: [email protected] or (888) 302-0765. 

---

This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. Performance may contain both live and back-tested data. Data is provided for illustrative purposes only, it does not represent actual performance of any client portfolio or account and it should not be interpreted as an indication of such performance. IFA Index Portfolios are recommended based on time horizon and risk tolerance. For more information about Index Fund Advisors, Inc, please review our brochure at https://www.adviserinfo.sec.gov/ or visit www.ifa.com. This is intended to be informational in nature and should not be construed as tax advice. IFA Taxes is a division of Index Fund Advisors, Inc.

Certified Public Accountant (CPA) is a license to provide accounting services to the public awarded by states upon passing their respective course work requirements and the Uniform Certified Public Accounting Examination.