Concentrated Position

An investment firm is said to have a concentrated position in a stock or an asset, if the given stock or asset holding comprises a majority, or substantially large, holding of its portfolio. A concentrated holding position influences the overall returns and trajectory of a portfolio. Investors take concentrated positions in assets due to a variety of factors, from sentimental reasons to deep convictions to fear over tax implications of a sale. 

While concentrated positions provide short-term benefits, research has proved that a well-diversified portfolio consisting of a variety of hedges and assets outperforms portfolios dominated by concentrated positions in the long term.

Basics of Concentrated Positions

An example of a concentrated position is that of a portfolio which has a 51% holding of, say, company ABC’s stock. As a result, approximately half of the portfolio’s net worth is tied to ABC’s stock price. Analysts predict that the upside to ABC’s stock price is tremendous; hence the portfolio could appreciate significantly in price. However, the downside risk is equally strong because a decline in ABC’s stock price could crash the portfolio’s valuation. Concentrated positions, thus, represent a high risk/reward trade-off in which the underlying asset’s risk, whether it is company-specific or sector-specific, is transferred to the portfolio.

There are several reasons why investors take concentrated positions in assets. Some of them are outlined below:

  • Tax implications: This is, perhaps, one of the most important factors governing the sale of a concentrated position. Many investors hold onto their positions, often multiplying it into a concentrated position, to avoid tax implications of a sale. A sale in the short-term would hit their portfolio with a massive tax bill. Therefore, investors take long-term positions to counter the effects of that bill.
  • Conviction about an industry or stock: Concentrated positions are accompanied with handsome risk/reward tradeoffs. If their research convinces them that a given asset is mispriced in the market, investors take a concentrated position in it to win big. Activist hedge funds, which conduct deep research in a company’s operating structure and industry, to take a massive long or short position against a stock are examples of this type of trading.
  • Sentimental reasons: Some investors become sentimentally attached to their positions. This conviction lets emotions cloud their judgement. The attachment may be due to various reasons. For example, they might have inherited the holding from a family member or it may have been the first stock they purchased.
  • Unwillingness to face reality: Some investors may initiate a concentrated position in a stock, if they believe that it will rise in the future. They may do this despite prevailing numbers and opinion against the stock and, against rational opinion, believe that the stock has growth prospects in its industry.

Given the potential rewards and pitfalls of concentrated positions, certain categories of investors are more partial to concentrated positions as compared to others. For example, past research has proved that hedge funds tend to make concentrated bets against or for companies. in other words, their returns are disproportionately dependent on the performance of select stocks rather than on a well-diversified portfolio of multiple types of financial instruments. On the other hand, mutual funds construct portfolios that are diversified across a range of stocks and industries to provide sustained returns. Index funds tend to track well-known indices to minimize risk.

Do Concentrated Positions Yield Greater Returns?

Much analysis of concentrated positions returns focuses on their short-term implications and gains. That approach makes sense when you consider the logic of high risk and high rewards. Over the long term, however, well-diversified portfolios, that include multiple asset types across industries, tend to outperform concentrated positions.

According to research, concentrated positions are more volatile and, hence, exposed to more risk that reduces their compounded growth rate. “Greater volatility in a portfolio reduces compounded growth rates and future wealth,” wrote research firm Baird & Co., in a note comparing volatility for portfolios with concentrated positions versus one with a well-diversified portfolio.

The firm compared two hypothetical investments of $1 million with the same average returns of 10% over a two-year period. Investment I, which had a concentrated position holding, rose by 50% one year and fell by 30% the next. Investment II, which was a well-diversified portfolio, rose 15% and 5% respectively in two years. Investment II generated a compounded growth rate of 9.9% versus 2.5% for Investment I. The initial capital of $1 million was $1.05 million after two years at Investment I and $1.2 million at Investment II.

Concentrated Position Strategies

Taking a concentrated position may seem like a gamble, albeit one backed by research and information, but it need not necessarily be one. There are various strategies that investors can adopt to minimize risk. Some of them are listed below.

  • Using options: Put and call options can be used in combination with each other in order to hedge against the possible downsides of a concentrated positions. For example, an equity collar protection strategy requires investors to purchase a put option that provides them with the right to sell the given stock in their portfolio at a pre-determined price in the future. They can combine it with the sale of a call option, to purchase the stock if it goes against their stated position, that provides them with premiums to finance purchase of put options.
  • Practicing a disciplined approach to investing: Investing can be an emotional affair and many of the reasons for concentrated positions outlined above are due to a lack of discipline, as far as investing is concerned. A disciplined approach to investing helps traders identify when to abandon a given position and cut their losses.
  • Using Trusts for trading: Trusts are used to minimize trading fees and tax implications. Trades conducted within a trust are not subject to capital gains taxes, unless funds contained in a trust are withdrawn. Trading fees for such trades is also considerably less, as compared to standard trades, significantly reducing the costs of holding a concentrated position over time.
  • Rebalancing: The sale of a large concentrated position is fraught with tax- and market-consequences. Investors can minimize its effect by selling small portions of the stock at a time and conducting the sale through different brokers to minimize its effect on the markets.

Concentrated Position FAQs

An investment firm is said to have a concentrated position in a stock or an asset, if the given stock or asset holding comprises a majority, or substantially large, holding of its portfolio. A concentrated holding position influences the overall returns and trajectory of a portfolio.
Over the long term, well-diversified portfolios that include multiple asset types across industries, tend to outperform concentrated positions. According to research, concentrated positions are more volatile and, hence, exposed to more risk that reduces their compounded growth rate. “Greater volatility in a portfolio reduces compounded growth rates and future wealth,” wrote research firm Baird & Co., in a note comparing volatility for portfolios with concentrated positions versus one with a well-diversified portfolio.
Some strategies that you can employ to manage concentrated positions are using options, practicing a disciplined approach to investing, using trusts for trading, and rebalancing.
Some reasons would be tax implications, conviction about a stock, sentimental reasons, or unwillingness to face reality.
Past research has proved that hedge funds tend to make concentrated bets against or for companies. in other words, their returns are disproportionately dependent on the performance of select stocks rather than on a well-diversified portfolio of multiple types of financial instruments.
True Tamplin, BSc, CEPF®

About the Author
True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, his interview on CBS, or check out his speaker profile on the CFA Institute website.