If you’ve been investing in financial markets, you’ve probably already heard of diversification. As one saying goes: “don’t put all of your eggs in one basket.” 

If a large percentage of your wealth is tied to the performance of one company, you’re in a precarious financial position. There are countless reasons why one company’s stock price could decline and possibly never recover (e.g. General Electric and Sears). The stock could also underperform the broader market. See this post to learn more. 

You may be thinking… “Wait a minute.. didn’t most wealthy people build wealth through concentrated positions? What about Bill Gates with Microsoft? What about Elon Musk with Tesla? 

The argument against diversification is absolutely valid. Many people have grown substantial wealth through concentrated positions. Examples include: 

• founders and early employees of successful startups
• executives of established Fortune 500 companies
• small business owners 
• real estate investors 

There is a saying attributed to Warren Buffet that goes “Diversification may preserve wealth, but concentration builds wealth.” So why then does Buffet say most people should invest in a highly-diversified S&P 500 index fund? 

The main question is: can you consistently identify the winners? 

For example, in order to beat the performance of the S&P 500 index, you would need to develop a strategy for consistently identifying stocks that will outperform the index (while excluding stocks that will underperform the index). You would buy the winners and exclude the losers. Here is the problem with this approach: there are already thousands of highly qualified portfolio managers (with teams of analysts) attempting to do this.    

If you work for a publicly-traded company, and you own shares of your employer’s stock (e.g. vested RSUs or Options), you’re betting that your employer’s stock will outperform a diversified basket of stocks (e.g. the S&P 500 index). Selling your shares and investing in the index is your alternative (i.e. benchmark). 

Private Companies

If you work for a startup (private company), and your employer has given you equity, you likely aren’t able to easily sell your shares (i.e. you cannot diversify).  You may be staying at the startup, hoping that your equity will one day become valuable. However, the statistics are grim. 

You often only hear about the success stories in the media: 

• A young startup is acquired by an established company for hundreds of millions of dollars
• A rapidly growing tech firm announces its intention to go public via an IPO 

What about the entrepreneurs whose businesses failed to live up to expectations? You rarely hear about them. This is known as survivorship bias. 

Some estimates show that 90% of all startups fail. An even more astonishing statistic: approximately 75% of venture-backed startups (startups funded by venture capital investors) do not return capital to their investors. These venture capital investors evaluate hundreds of companies, hire teams of analysts, and deploy successful managers to help founders grow their startups. Even these experienced professionals have difficulty picking the winners and producing superior returns for their investors. 

Benefits of Diversification

Most people simply cannot afford to make a huge bet on one company. This even applies to well-established corporate giants. Many historically great companies have seen significant declines over the last decade (for example: GE and Sears). Most investors want assurances that they won’t experience a 70%+ decline in portfolio value. A decline of that magnitude is incredibly difficult to recover from. 

• 50% decline requires a 100% following return to get back to even
• 70% decline requires a 233% following return to get back to even
• 80% decline requires a 400% following return to get back to even 

This is where the idea of diversification comes in. With a well-diversified portfolio, you can reduce the risk of a massive drawdown while building reasonable expectations of long-term return. 

You can build estimates of future returns and risks (volatility;  max drawdown) by observing how diversified portfolios have behaved in the past. There is a substantial amount of historical market data available. You can have some confidence that your portfolio will not decline 70%+ if you structure it appropriately. This isn’t to say that a well diversified portfolio will never decline by 70%+ (nothing is guaranteed in the markets). However, we can lower the probability of this outcome with proper portfolio design. 

The risk of significant losses declines when you own assets in various categories. If you own 100 stocks through a mutual fund or ETF, and one of those companies goes bankrupt, it will have a minimal impact on the overall value of the fund. With portfolio construction, a key objective is maximizing return relative to a given level of risk. By combining investments that behave differently (i.e. assets with uncorrelated returns), we can reduce the risk of the portfolio. 

Many individuals have a goal of creating “supplemental income streams.” With a diversified portfolio, you receive income streams from a wide variety of sources. For example, a portfolio would receive cash flows from: 

• dividends paid by companies  
• net operating income produced by real estate properties (eg. REITs)
• interest from bonds issued by various public and private institutions 

Conclusion

If you’re fortunate enough to have built wealth through a concentrated employer equity position… Congratulations! You’ve likely been part of an exceptional team and seen the company grow over time.

Although we’d like to believe our company’s stock will grow forever, history tells us a different story. By the time a corporation becomes a market-leader, it faces an onslaught of competition. Competitors can take market share through innovation, or they can hire-away a company’s top executives. Capitalism rewards companies that can step into the marketplace and provide a higher quality product or service to consumers at a lower price. 

• Will the company be a market-leader 10 years from now? 
• Will the company continue to exceed analyst expectations and outperform the broader market going forward? 

These are questions you should be asking if your employer equity position constitutes a large portion of your total portfolio, or if you have heavy stock exposure to any one particular company.  

Your mindset at some point may shift from: 

How do I aggressively grow my wealth? 

-to- 

How do I protect my wealth while still achieving growth? 

Of course you can still maintain a position in your company’s stock. However, make sure the size of your employer stock position reflects your financial goals and risk preferences.