Are You Holding a Concentrated Position? Here are 6 Strategies to Help Diversify Your Portfolio
In our backyard in the Seattle-Bellevue area, we have giant tech companies all offering a significant portion of compensation in the form of employee stock plans: Microsoft, Boeing, Amazon, Google, Facebook, Zillow, and many more. Since many of our clients work for these companies, many of them also have concentrated stock positions. The combination of strong market returns over the past ten years or so, coupled with significant compensation from these companies in stock options, has led to many individuals with a substantial piece of their wealth tied to one individual company. Don't get me wrong; this is a great problem to have and usually means that stock has performed very well.
So, what is a concentrated stock position?
A concentrated position, also referred to as concentrated stock position or concentrated stock, occurs when an individual investor owns shares of a specific stock that makes up a large percentage of their overall portfolio. If you find a large percentage of your overall portfolio is tied to one stock, you may be setting yourself up for a concentrated stock challenge, and it may be important to diversify. But why is diversification important, and how can one begin this process without major tax impacts? These are the challenges we face as advisors when it comes to concentrated positions.
First, it is important to share that there is no hard and fast rule to suggest a position is too concentrated. If you are younger and willing to take on more risk, it may be okay to have a larger position in an individual equity. Alternatively, it may be wise for someone closer to retirement age to keep this position a smaller percentage of their portfolio to manage risk and preserve their wealth. As you evaluate your concentration risk, keep in mind not only the direct percentage this position makes up of your net worth today but also how ongoing savings or vesting schedules may affect this concentration. For someone with 5% of their portfolio in an individual position, there may not be a concentration issue yet. But what if you are also maxing out an ESPP and receive an extra 10% of your worth each year in stock options? You can probably see that this individual may quickly run into concentration issues and may be wise to be proactive in this scenario by developing a thoughtful strategy before concentration becomes a problem.
Why is it important to avoid concentrated stock positions?
Discussions around diversifying a concentrated position are always difficult and emotional. Often the reason you find yourself with a concentrated stock position is because the stock you own has seen significant returns and has grown to be a massive contributor to your overall net worth. Especially here in 2021, with the market returns we have seen over the past ten years, almost regardless of the stock itself, our individual stock positions have seen a significant run-up with the markets and may have grown into a big piece of our portfolio. It can be challenging to put our emotions aside and think objectively, given the history and how much this growth has contributed to your success.
We have all heard the old adage that past performance does not indicate future performance, which must be kept top of mind. Have you heard of the hot hand fallacy? It is typically used in sports and suggests that if an individual is "hot" based on their performance, they will continue this streak. As humans, it is natural to feel that what we have experienced historically will continue moving forward. We as humans also often feel too confident that we can predict when things may turn around, but this is much easier said than done. Think back to some of the stocks we thought were rock solid in their prime and now are nearly or entirely nonexistent: Kodak, Pets.com, Enron, Nokia, Lehman Brothers, and many more. We all feel that the company we are a part of or have invested in will never have business challenges these giants faced in their heyday. However, when these companies were some of the top companies in the world, people felt that they were unstoppable as well. Research suggests that the average lifespan of a company listed on the S&P is only 18 years… 18 years! You are probably investing for a much longer timeline than 18 years, so diversifying your holdings is critical and one of the few ways to ensure you are keeping your emotional ties in check.
On another note, something that I feel is not talked about nearly enough is that lower volatility can actually lead to better performance. With an individual stock, there are significant ups and downs over the course of any given day, month, year, or decade. This volatility can create opportunities, but it is also important to understand that any downturn creates challenges in climbing back out of the hole. If your stock is down 50%, you need to experience a 100% return from that point just to get back to where you started. This example shows how lower volatility (less fluctuation in your portfolio) can actually lead to not only better performance but more steady, predictable returns.
More often than not, the reason we end up with a concentrated stock position is in some way tied to employment. Maybe you are an executive, or your company provides stocks options as a significant part of their compensation plan. Either way, this creates its own challenge to avoid keeping all of your eggs in your company's basket. Not only do you need to think about stock concentration issues, but your salary, your benefits, your retirement, your future, and your success are all hinging entirely on your employer. For us Washingtonians, we still remember Washington Mutual (WaMu) very well. We saw firsthand how impactful keeping all of your finances tied to one company could be. If your company were to go bankrupt like WaMu, not only are you left searching for a job, but you may also realize a significant portion of your net worth has been lost overnight with no assets to bridge the gap in employment. However confident you may be in your company, it may be wise to at least begin minimizing the risk to your net worth by diversifying your individual stock exposure to ensure there is not too much concentration of your future entirely tied to your company.
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6 Strategies to Reduce Concentrated Stock Positions
If you are worried about your concentrated position, you are probably concerned about tax considerations to diversify. Coming up with a plan to effectively diversify over time and thoughtfully sell a concentrated position is a crucial part of financial planning. Although there is no silver bullet when it comes to concentrated stock, there are a few strategies to explore to help manage taxation along the way.
Net Unrealized Appreciation (NUA)
NUA is a strategy only available to those with employer stock in their 401(k) but can be extremely effective if used properly. NUA essentially allows you to carve out employer stock from the same employer retirement plan to be treated and taxed as a non-qualified asset moving forward, meaning capital gains rates as opposed to ordinary income. Typically this is most effective if you have a stock holding with a large discrepancy between the basis and the current value. When exercising NUA, the basis of the stock taken out of the 401k is taxed as ordinary income, so it is important to be strategic in the timing and use of NUA. If done properly, it can allow a significant portion of your stock holding to be taxed at much more favorable capital gains rates moving forward.
A more simple strategy is to sell incrementally
To manage taxation, you can simply spread out your selling over the course of a few years to minimize the capital gains tax you may experience in one year to spread out the burden over many. Here in Washington State, starting in 2022, we most likely will also have a capital gains tax above certain thresholds. You may want to sell incrementally to minimize these additional taxes that can be easily avoided. Many employees with sizeable concentrated stock positions may be restricted from selling, so you may consider filing a 10b5-1 Plan which allows you to prove a selling strategy in advance, avoiding any concerns of restrictions and insider trading issues.
Another option for those who have to consider insider trading concerns is the use of a blind trust
A blind trust allows a third party to manage your stock with discretion, meaning they can choose when and how much they sell based on what they feel is best. Selling is all done discretionarily, which means this is without your direct order allowing for more freedom to do what may be best.
Using options or stop loss orders
Often, when we run into sizeable concentrated stock positions, the stock may not be a bad holding in the first place; we want to be sure to diversify. In this situation, using options or stop loss orders can help to hedge the downside without selling the stock right out of the gate. These strategies can allow you to minimize your downside risk or set a certain price in which you will automatically sell a portion of your holding to help be sure some of the gains you have seen will be recognized. In this scenario, it is also essential to consider taking chips off the table on the upside as well, so the concentration doesn't become more considerable. This strategy also creates some version of a floor if the stock were to turn the other way.
Gifting appreciated stock is another great option if estate planning is important to you
If you have a charity that is near to you and your family, gifting appreciated stock can be an excellent opportunity to help minimize your estate, spread out single stock risk, and make an impact to the organization of your choosing. Gifting appreciated stock allows you to give a much higher valued asset. Then, the charity will receive tax benefits that we do not get as individuals when they sell this appreciated stock.
Exchange-traded funds are another way to explore diversification and tax management all in one
Exchange funds may allow you to transfer your concentrated stock into a particular fund that is tied to a specific index (maybe the S&P 500, for instance). Once the stock is transferred into the fund, typically, there may be a waiting period in which you will not have access to the funds. After this period, you receive a basket of stocks with a much more diversified portfolio in which you can sell or hold as you see fit from there.
Stock positions through options or early investment can be a great wealth builder over a lifetime. If you have been fortunate enough to experience significant stock gains and find yourself with a concentrated sock position, diversification is critical to help ensure you can preserve the wealth you have worked so hard to build. Although managing taxation to be as efficient as possible within your investment strategies is important, taxation around these investments is sometimes viewed as taboo and to be avoided at all costs. When you find concentration issues or analysis suggesting to sell a position, taxation is still critical but may not always be the driving factor. Making decisions to improve your portfolio should be the priority and taxes as a consideration rather than taxes alone driving your portfolio decisions. Paying tax is often a necessary evil to make smart portfolio changes. Minimizing taxes at the sacrifice of your portfolio as a whole is like stepping over a dollar to pick up a dime.
Whether you are concerned with taxation or not, concentrated stock positions can be tricky to develop a thoughtful exit strategy. You may find that one of these strategies helps you diversify or even combine the above methods. The key is to make sure the strategy you utilize fits into the bigger picture in your financial plan and that you fully understand all angles before making important decisions on how this is handled.