Solutions For Concentrated Positions

By Steven Merkel AAA

Many retail investors run the risk, at some point in their lives, of overexposure - owning too much of one company's stock. It could be that you worked for a large corporation such as Exxon Mobil and acquired a major portion of your wealth in the form of stock options, or maybe you just fell in love with a particular stock and bought a ton of shares over the years. Regardless of how it happened, any individual holding that makes up more than 30% of your overall investment holdings is considered a "concentrated position."

How it Happens
There can be many different reasons why you ended up with a large position in a particular stock, but the most common typically involve emotional attachment - especially if the stock's performance has made you rich. Large individual positions are built and acquired every day through employer retirement plans, inheritances, stock options and the selling of businesses. If you were fortunate enough to have achieved superior returns on a particular stock, you may have continued to buy shares over the years.

From a tax standpoint, you may be retaining the position or delaying a portfolio rebalance because you do not want to pay taxes on capital gains, or maybe you have restricted stock (shares that can only be sold in the future). In any case, you need to be aware of the dangers of holding such a concentrated position. And you need to exercise caution. 

The Pitfalls of Single Stock Ownership
Concentrated stock creates a problem because it makes a large portion of your wealth dependent on the movement of one particular stock. As a result, you are faced with an inferior risk/return profile. Why? Current research has revealed that the average stock tends to lag the market. Given that two-thirds of the average stocks underperform the market, it is more likely than not that a concentrated stock position will underperform the market. Knowing this should be reason enough to seek more diversification within your portfolio. Single stock ownership exposes you to higher volatility, lower liquidity and higher risk than ownership of a diversified portfolio

When to Divest Your Concentrated Position
Diversification can both reduce risk and foster higher long-term growth, but when is the best time to divest your concentrated position? Assuming that a high portion of your net worth is concentrated in one stock, selling some of your shares might be a prudent decision if you are facing any of the life circumstances listed in the table below:
 

Condition Optimal Response
Long Time Horizon Divest
Low Risk Tolerance Divest
Low Tax Costs Divest
High Stock Volatility Divest
High Spending Needs Divest

Of course, each investor's personal situation will determine exactly how many shares s/he should divest. But, at a minimum, they should divest enough to eliminate overexposure to a particular company, business sector or economy. The optimal amount to sell rises with longer time horizons for holding the concentrated position, lower risk tolerance, lower tax implications attached to selling the stock, and higher single-stock volatility.

Strategies for Divesting Your Position

Using Share Selection - This strategy involves liquidating a large portion of your concentrated stock position now and taking advantage of the long-term capital gains rate. If you select your shares wisely, you will sell the ones with the highest cost basis, thus minimizing your overall capital gain. 

Sell Stock in Equal Stages - You might decide that you wish to sell 75% of your concentrated stock over the next five years. By spreading your sales out over future years, you lower your exposure to capital gains taxes in any one given year. If in any given year your income level is lower than in previous years, you may find it beneficial to sell a larger portion of your stocks then.

Gifting - If you're still concerned about the tax bill that may result from the sale, you may want to consider gifting the stock to either your children/grandchildren or your favorite charity. An individual can gift $11,000 per year to any family member free of gift taxes, and a charitable gift might even get you a tax deduction.

Hedge Your Position - For some, hedging strategies can "do it all," protecting wealth, delaying taxes and diversifying a portfolio all at once. Let's take a look at a few of your options:

  • Charitable Remainder Trusts (CRT) - Highly appreciated stock is transferred into a charitable trust, and the investor receives both a charitable deduction and an annual income stream (assuming he is the beneficiaries) from the trust.
  • Equity Collars/Options Strategies - Collars are created by the simultaneous purchase of a put option and sale of a call option. Using this strategy provides the investor with a guarantee that his or her concentrated position will have a value within the minimum and maximum price for the period the options cover. Buying puts and selling calls can also help reduce single stock exposure. However, keep in mind that transactions that effectively offset a stock position may cause the realization of a capital gain by way of the constructive sale rule (Section 1259 of the Internal Revenue Code). This rule was introduced to stop investors from avoiding capital gains tax by simply offsetting speculative and hedge positions.
  • Exchange Concentrated Stock for Limited Partnership Ownership - An investor can place shares of his or her appreciated stock into a limited partnership in exchange for an interest in partnership. Ideally, the partnership would hold other stocks, effectively providing the investor with shares in a larger diversified portfolio. You can capitalize on a number of estate-planning benefits stemming from this sort of exchange, since units in the partnership may be transferred between generations of families without the realization of capital gains.
  • Prepaid Variable Forwards (PVF) - Although similar to a collar, with prepaid variable forwards contract the investor receives an up-front payment (typically 80-90% of value) in exchange for delivery of a variable amount of shares or cash in the future. A floor in the forward contract protects the investor from some decline in the stock's price and also still allows forward contract holders the benefit of stock price appreciation.

The Bottom Line
Although many investors have profited quite handsomely from retaining and accumulating large quantities of one particular stock, it is important for you to recognize the risk and the exposure to volatility associated with this strategy. 

comments powered by Disqus
Related Articles
  1. The Pitfalls Of Diversification
    Investing Basics

    The Pitfalls Of Diversification

  2. Naive Diversification Vs. Optimization
    Fundamental Analysis

    Naive Diversification Vs. Optimization

  3. The Importance Of Diversification
    Bonds & Fixed Income

    The Importance Of Diversification

  4. Top 4 Signs Of Over-Diversification
    Brokers

    Top 4 Signs Of Over-Diversification

  5. When Geographic Diversification Fails
    Active Trading

    When Geographic Diversification Fails

Trading Center