“I’m about five inches from being an outstanding golfer. That’s the distance my left ear is from my right.”  – Ben Crenshaw

We admire those visionaries who seize a unique opportunity and work single-mindedly to realize their ambition and create exciting, valuable businesses.  Often, when the numbers and timing make sense, an entrepreneur decides to sell his or her business, and part of the reward can be a concentrated position in the acquiring company stock.  Over the long run, some companies can outperform the broad market and maintain their value.  More often, the risk of a concentrated position far outweighs its potential reward.

A recent study analyzed the Russell 3000 Index, which is a proxy for the broad U.S. market, and defined a “catastrophic loss” as a decline of 70% or more in the price of a stock from its peak, with such little recovery that the eventual loss is 60% or more.  The study then analyzed how often this takes place.

On average, approximately 40% of all the Russell 3000 Index stocks experienced catastrophic declines, as defined.  (The 70% decline is the study’s subjective cutoff point; most investors see much smaller permanent declines as equally unacceptable.)  As you can see from the chart below, this phenomenon is not limited to Energy or Technology sectors, as you might expect, but across all sectors.  Moreover, although these loss rates tend to rise during recessions and market corrections, there is a steady pace of declines even during economic expansions.

We understand that each business owner is unique, but certain patterns and facts are universal.  As difficult as it is to build a company and create wealth, it is equally as difficult to maintain it.

Statistics support the reality that holding a concentrated stock position may be destructive to that hard-built wealth.  No matter how well an individual knows his or her industry and stock, the factors outside of management control, such as fraud by non-executive employees, technological innovation creating obsolescence, and consolidation, to name a few, can permanently and severely suppress a company’s share price, oftentimes without recovery.