Entrepreneur, Executive, and Investor - The Stages of Equity Holding

Within the CFA L3 exam's focus on concentrated positions (which we started covering here), the stages of equity holding explain how a business owner or corporate executive might obtain wealth through the equity of a single company and how their psychology around their acceptance of the concentrated position and its higher risk depends on the degree of control and attachment they have over the business. 

The 3 Stages of Ownership

There are three primary buckets of ownership. These are the entrepreneur, the executive and the investor.

Each of these different stages simultaneously explain the comfort level in terms of holding specific risk, i.e. of being concentrated, and the psychology around gradually relinquishing that control and diversifying your portfolio (partly) as a result. 

Entrepreneur Stage

If an individual is an entrepreneur that built a company they may have a psychological attachment to the stock. More important, if they are still closely affiliated with the company (say as the CEO) they may not feel a need to diversify as they still maintain a great deal of control over the future of the company and its stock price. Thus an entrepreneur will be more comfortable with the specific risk of holding a lot of their wealth in a single position.

Executive Stage

An executive, whose compensation may largely consist of equity grants, will have some overlap with an entrepreneur in terms of how much control they believe they exert over the future of their company. Their comfort/desire to maintain the specific risk of a concentrated position depends directly on the degree of control they believe they exert over the future of the company. Think of this as the intermediate, transitional stage between viewing oneself as an entrepreneur and as an investor.

Investor Stage

At this point an investor is less attached to a security and doesn’t exert control over the company. An investor is more concerned with diversifying away specific risk in a portfolio as much as possible. To do so an investor embarks on a process of transitioning from a concentrated portfolio to an active portfolio with a large core holding, and eventually to a truly diverse portfolio.

We can summarize this as follows:


Degree of Control vs. Concentrated Positions/Specific Risk

So if you look at my beautiful hand-drawn graph, we have risk on the Y axis, and the time or life cycle of this investor on the horizontal axis.

We start with entrepreneurial stage. Maybe the person in question has built a company that they have a psychological attachment to, or more importantly, at this stage they're probably still really closely affiliated with the company. They might be the CEO for example, so they maintain a great deal of control over the direction of the business and believe they have a strong impact on its ultimate value. As a result, they might not feel a very strong need to diversify.

In other words, at the entpreneurial stage one is comfortable holding that specific risk and having a lot of one's portfolio in one basket.

But over time things change. Let's say the company gets bigger...or maybe you didn't start as an entrepreneur but you are a high ranking executive at a company...In this case you still have significant control over the business but there's less control compared to an entrepreneur.

With less influence you become less and less comfortable holding that specific risk, and you might be thinking about diversifying a bit more. Thus this executive stage is the intermediate transitional stage between viewing oneself as an entrepreneur, and being really comfortable holding all that risk, and transitioning into the investor stage where you're much less attached to the security of the company.

In the investor stage you probably don't have control over the company itself. That means you're more concerned with diversifying away that specific risk, and that's the stage at which the rest of the reading highlights the mechanics of diversifying the strategies of doing so.


How Concentrated Positions relate to behavioral finance

I guess before we move into those mechanics, the last thing to touch on here is you should look at that graph and these bullets here and understand how some of the behavioral biases that we've covered play in (see more on the biases in this blog post).

Specifically, illusion of control, overconfidence, status quo bias, and endowment effect are all related here in the sense that they impede an individual from thinking rationally about diversifying, so as a portfolio manager, you need to be really cognizant of any of those roadblocks, and you might mirror goal based investing, and lump assets into buckets that the investor can understand, and the concentrated position might be one of those buckets.

So how do we incorporate psychological considerations into the asset allocation process?

Basically we do this by using goal-based planning and separating assets into three buckets—a personal risk bucket, a market risk bucket, and an aspirational risk bucket. Just like with Goal Based Investing, the aspirational bucket contains the highest risk positions, i.e. this is where the concentrated position would be placed. Framing an individual’s assets in this way can be a productive way to start the conversation about whether they should begin to diversify a concentrated position.


The Entrepreneur, Executive, and Investor Stages of Equity Holding

Stages of Equity Holding - concentrated positions CFA