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Concentrated Stock Positions: The Backroom Joke of Wall Street


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Concentrated Stock Positions: The Backroom Joke of Wall Street

A concentrated stock risk rating gives an idea of how much of a concentration in a given stock exists in the portfolio. The world’s wealthiest people have the most concentrated stock positions.

Just think of Warren Buffett, Bill Gates, Jeff Bezos, and so many other corporate leaders. It’s a backroom joke on Wall Street that the way to get rich is through concentrated stock positions, but the way to stay rich is to diversify.

The logic makes extraordinary sense, but often only to financial advisors. One of the most pressing issues that advisors face is how to deal with clients who have fallen in love with certain stocks, or who have large, inherited positions.

By showing clients how a concentrated stock position influences the value of their entire portfolio, especially if the position suffers a sharp loss, many StratiFi advisors find that they finally get clients to understand the risk. And that is really the power of the PRISM concentrated-stock analysis. The rating provides an easy-to-understand snapshot of how this piece of the investment puzzle influences the entire portfolio.

To compute this rating we order stocks by decreasing market weights, normalize and turn this vector into a 0-1 floating range. We then evaluate the cumulative market weight function vs this stock vector to extract the x-axis value of the intersection with a market weight of 50%.

Because this is a monotonic, concave function with a monotonically decreasing derivative, the intersect can not be less than 0.5. We then magnify this intersection value range by using an exponential function. 

A portfolio will exhibit:

A low (good) rating if the curve of the function has a very slow rise indicating no or small allocation to stock positions relative to the rest of the portfolio 

A high (bad) rating if the curve of the function has a sharp rise, especially at the origin indicating it has a large allocation to at least one stock position relative to the rest of the portfolio

An average rating if the curve of the function has a slow, steady rise indicating it has a moderate allocation to a few stock positions relative to the rest of the portfolio.

A client may decide to do nothing even when confronted with facts, but at least advisors have documented that they have explained the risks. Should the PRISM rating prompt a client to diversify the position then advisors have made a breakthrough.

Our PRISM™ risk analysis software uses a blend of risk tolerance questionnaires, historical market events, and current market signals to provide advisors with all the data they need to know their customers and plan accordingly. Contact us to find out how StratiFi can help your practice and clients monitor risk across all investment holdings regardless of market conditions.

Akhil Lodha
Akhil Lodha Author
Co-founder & CEO StratiFi Technologies

Building the industry standard for understanding portfolio risk through cutting- edge technology at Stratifi.

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