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| First Person: Industry View |
Timing Is Everything
Steven R. Bell and Michael Leon
11/01/2004
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Steven R. Bell and Michael Leon are senior vice presidents at the Northern Trust
Co., based in Chicago. Bell heads Northern Trust’s Wealth Management Group and
Leon leads the company’s Alternative Investment Solutions Group.
Timing is crucial for investors who have a significant portion of their net
worth concentrated in a single stock. Holders of concentrated stock positions
need to focus on the timing issues with respect to any
given diversification
strategy they may consider. These are a factor of their ties to the security,
tolerance for risk, and tax situation.
Investors must consider their time
horizon—the period in which they wish to achieve a specific financial goal—as
well as any interim cash requirements. The longer the time horizon, the more
necessary a diversified portfolio becomes. More often than not, an investor who
has a 10-year time horizon will see a diversified portfolio outperform a single
stock, even after selling the position and paying taxes. Even high-profile,
blue-chip companies such as Microsoft and General Electric have experienced
significant price and volume volatility over the last 10 years, as represented
in Table 1.
Ties to the Security: One’s ties to a stock often govern the
timing of a transaction. If the investor qualifies as an insider or an
affiliate, he or she may be subject to sale restrictions and disclosure
requirements. If the investor has strong family or personal ties to the stock,
he should consider his willingness to forfeit voting and dividend
rights.
Tolerance for Risk: Investors with concentrated stock holdings must
also assess their willingness to weather market fluctuations in asset value.
Failure to do so can lead to emotional decisions in the event of adverse price
movements. We must also examine the stock’s volatility, which measures an
asset’s inherent risk of rising or falling sharply in price within a short time.
The average single stock has about twice the volatility of a well-diversified
portfolio such as the Standard & Poor’s 500 Stock Index; technology and
Internet stocks are three and four times as volatile, respectively.
Why does
volatility matter? Because, all other factors being equal, the more volatile a
stock is, the lower its long-term growth rate will be. In other words,
volatility reduces long-term returns. Diversification reduces volatility, thus
improving long-term returns.
Table 2 offers an illustration. Three stocks—A,
B and C—all have starting values of $100 and an arithmetic average return of 10
percent per year. However, their real rates of return—the actual compounded
value they deliver—vary substantially. As illustrated, Stock A has the lowest
volatility and the highest real rate of return, while Stock C has the highest
volatility and the lowest compounded rate of return. Lowering the volatility of
an overall portfolio can positively benefit real rates of return.
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