Solutions For Concentrated Positions

If you're one of the many baby boomers preparing to retire within the next 10 years, you may soon be faced with a problem regarding your stock holdings. That problem is overexposure, or 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. If you want a second opinion on this issue, ask any former Enron employee. (For more on this, read What Enron Taught Us About Retirement Plans.)

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. For decades, investors have held to the conventional wisdom that the more volatile a stock, the higher the expected return. However, recent studies have found the opposite: the more volatile the stock, the lower the expected growth. A study by Bernstein Investment Research in March 2004 looked at a 20-year period (1984-2003) and revealed that stocks with average volatility have lagged the S&P level returns by nearly three percentage points per year. For the most volatile quartile of stocks, the drag on performance has been close to seven points. 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. (To learn more about the importance of diversification, see A Guide To Portfolio Construction and The Dangers of Over-Diversification.)

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 Table A:

Table A Condition: Longer Time Horizon Low Risk Tolerance Low Tax Costs High Stock Volatility High Spending Needs Optimal Response: Divest Divest Divest Divest 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 low 15% 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. (For further reading, see Selling Losing Securities For A Tax Advantage.)

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 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 PVFs 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.

Conclusion
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. In the last five years, many investors have lost a significant portion of their investment assets due to overexposure to a single company's stock or a lack of portfolio diversification. Numerous lawsuits have plagued the financial industry and many workers still dream of eventually winning compensation for their losses, but the reality is that for most of these people, their dreams of early retirement have been shattered. Don't let this happen to you - invest wisely and diversify.