Concentrated Stock Positions: Compounding Versus Risk

Charlie’s portfolio was concentrated in very few securities and therefore his record was much more volatile but it was based on the same discount-from-value approach. He was willing to accept greater peaks and valleys of performance, and he happens to be a fellow whose whole psyche goes toward concentration, with the results shown. – Warren Buffett discussing Charlie Munger’s investment process in Damn Right! by Janet Lowe

Berkshire Hathaway’s (BRK/A, BRK/B) Warren Buffett and his late partner Charlie Munger are considered the greatest investment duo of all time. Munger’s investment strategy tended to be very concentrated, with the Daily Journal Corporation (DJCO) portfolio that he controlled typically having only four or five central holdings. Even Berkshire’s $259 billion publicly traded stock portfolio consists of only 36 stocks, with 71% of the portfolio value in the top five holdings.

A study by Antti Petajisto examined the long-term performance of concentrated stock positions, noting that these positions tend to underperform and add risk to portfolios. This article will discuss the evidence and its implications for taxes, taking into account this information. In addition, some solutions will be reviewed.

Performance Of Concentrated Holdings

Some stock market math is needed to help put the underperformance data in its proper context. According to a paper by Hendrik Bessembinder recently examining the returns on 29,078 US stocks from 1926 through 2023, over half of all stocks, 51.6% to be precise, had negative cumulative returns. How can there be all these losing stocks when the S&P 500 has an annualized return of 9.8% from 1928 to 2023?

The complex answer is that stock returns have strong positive skewness. However, a simple example of long-term positive compound returns provides a more easily digestible answer. Take a portfolio of just two stocks selling for $100 per share. The first stock grows at a 9.8% annualized rate, while the second stock declines at a 9.8% annualized rate over thirty years. One would think that our total portfolio would stagnate during that period, as the losses in one stock would offset the gains in the other, but compound returns make our intuition incorrect. The exponential return on our positively performing company outweighs that of the loser. This portfolio grew to be worth $1,657, representing a 7.3% annualized rate of return. In other words, the highest-performing stocks in the S&P 500 more than compensate for the losers over time.

When examining concentrated, non-diversified portfolios, the median return should be the primary focus in assessing the risk of potential outcomes. The ten-year median return on an individual US stock was -7.9% or -0.82% per year relative to the overall market. Interestingly, for stocks that were in the top 20% of performers in the previous five years, the ten-year median relative return was a dismal -17.8% or -1.94% per year. The mean return in both cases is positive because the smaller subset of fabulously performing stocks dominates the return across a diversified portfolio.

Portfolio Volatility And Concentrated Holdings

Risk to us is 1) the risk of permanent loss of capital, or 2) the risk of inadequate return. – Charlie Munger

Petajisto found that the return volatility of portfolios with a single holding of up to 10% was little different from a diversified portfolio. He noted that volatility increases begin to become meaningful at individual holding weights of 10-20%. Once a single holding reaches 30% or more, diversification is of little help in controlling volatility.

While academics and some practitioners define stock risk as volatility, it is only one measure of risk among others. Volatility measures how much the price of a stock fluctuates over time, which is only meaningful if one needs to sell or becomes uncomfortable with that price movement. Volatility is typically used as a measure of risk precisely because it is easily measurable.

Munger was comfortable with the added volatility of holding a small number of stocks because he didn’t believe volatility was meaningful for the long-term investor. His focus was on permanent loss of capital and a reasonable return on his investment.

Taxes And Concentrated Holdings

Sit on your ass investing. You’re paying less to brokers, you’re listening to less nonsense, and if it works, the tax system gives you an extra one, two, or three percentage points per annum. – Charlie Munger

While the case for some concentration in holdings can be made for highly skilled investors with a high tolerance for volatility, taxes have a significant impact on the added reason for retaining these outsized holdings. Unrealized capital gains on stocks are akin to an interest-free loan from the government, so the longer an investor can utilize the Internal Revenue Service’s share of the gain to compound wealth, the better.

Since the point of this exercise is to look at holdings that grew into concentrated holdings, the calculation around short-term capital gains isn’t relevant. However, the higher tax rate on short-term gains makes avoidance generally the best policy if possible. Many assumptions must be made to illustrate the additional return required to offset the tax payment for taking a taxable long-term capital gain on a stock; however, the following examples will provide a reasonable model for decision-making.

In this example, the stock is now worth $100,000 and has a tax basis of $65,000, and the investor’s long-term capital gains rate is 28.8%. Depending on how long you hold the new investment you buy with what remains of the sale proceeds after paying the tax, the latest investment needs to outperform your previous by 3.6% annualized for three years or 1.1% for ten years to make up for the tax payment.

With the same assumptions as before, but the stock is now worth $100,000 and has a tax basis of $20,000, the new investment purchase must outperform your previous by 9.1% annualized for three years or 2.7% for ten years to make up for the tax payment. Massive winners lead to a larger tax hurdle for sale despite possible forward-looking underperformance.

While the variables make a difference, and there are cases where it would be appropriate, short-term capital gains should generally be avoided if the goal is to maximize after-tax wealth. Even long-term gains retain a significant hurdle for deciding to exit a winning investment in a taxable account. The conclusion is that investors owning companies that are expected to be excellent long-term should be willing to tolerate short-term underperformance to utilize the power of compound returns and maximize after-tax wealth.

Apple And Buffett

We expect to hold these securities for a long time. In fact, when we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever. We are just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint. – Warren Buffett

Even Warren Buffett’s tolerance for concentrated positions has its limits, as demonstrated by Berkshire Hathaway’s history of owning Apple (AAPL). Berkshire Hathaway began amassing a position in the first quarter of 2016. By the third quarter of 2023, Apple had grown to account for 52% of Berkshire’s publicly traded stock portfolio, with a value of nearly $157 billion. During this period, Apple achieved a total return of 613.8%, or 28.9% annualized, compared to the S&P 500’s total return of 141.72%, or 12.1% annualized.

Berkshire began to trim its position in the fourth quarter of 2023 and sold a sizable stake over four straight quarters. As of the end of the first quarter of 2025, Apple remains Berkshire’s largest publicly traded stock holding at 26% of the portfolio, with the stake worth about $67 billion.

At the 2024 annual meeting, one of the most significant disclosures was that Berkshire Hathaway sold nearly $20 billion of its massive stake in Apple (AAPL) during the first quarter of the year. Despite selling about 13% of its stake that quarter, Buffett said it’s likely that Apple will remain the largest common stock holding at the end of the year. Buffett noted that Berkshire’s holdings in American Express (AXP) and Coca-Cola (KO) were “wonderful” businesses but said that Apple is an even better one.

Apple sold for as low as 10 times earnings in 2016, but by the fourth quarter of 2023, when Berkshire began to sell in earnest, the valuation had blossomed to 30 times earnings. Buffett has never given a definitive answer regarding the trimming of Apple. Still, one can surmise that risk management, combined with the higher valuation, making the pace of past gains unlikely to be replicated, likely led to the sales despite the enormous tax bill.

Conclusions

The ingredients of Warren’s and Charlie’s great investment performance are simple: (a) a lot of investments in which they did decently, (b) a relatively small number of big winners that they invested in heavily and held for decades, and (c) relatively few big losers. – Howard Marks

Buffett and Munger certainly utilized the power of compound returns by allowing winners to run and selling the losers over a long period, assisting in maximizing after-tax wealth. This strategy wasn’t always set in stone, as the Apple investment shows. Investors need to be mindful of the additional risk that comes with successful concentrated positions, weighing it against the tax costs, and consider the fundamental valuation of the business.

The data show that extreme upside winners tend to face some headwinds, so the probabilities need to be considered when examining possible future outcomes. Harvesting capital losses to offset realized gains from trimming concentrated positions is an effective tool used by Warren Buffett and intelligent wealth managers. Beyond the scope of this article, there are more innovative strategies available to qualified high-net-worth investors that can be potent ways to diversify concentrated stock positions in a tax-efficient manner.