Don’t Put All Your Eggs in One Basket
When a single stock is more than 10% of your total investable assets, it often means that you’ve had good fortune—an inheritance, a successful bet on a young company or generous equity compensation. But a concentrated stock position can make your portfolio much riskier than it should be.
While a concentrated position can create tremendous wealth if the stock does well, it can also be easily erased. Concentrated stock positions carry a high degree of risk because they are vulnerable to sudden and unpredictable changes in the market. That’s why managing concentrated stock positions is so important.
Options for Lowering Concentration Risk
Suppose that XYZ stock accounts for 30% of your $1 million portfolio. If XYZ stock falls 50% while the rest of your holdings remain even, your portfolio would be down 15%. That’s the kind of volatility no investor wants.
Those with concentrated stock positions often understand the elevated risk but may delay dealing with the problem for any number of reasons. If the stock was inherited, there may be an emotional attachment. In many cases, investors fear that selling concentrated stock will trigger a big tax bill. The good news is that there are several time-tested strategies for managing concentrated positions. The right one for you depends in part on your long-term planning goals, tolerance for risk and time horizon.
Selling Some or All of Your Stock
A straightforward option is to sell your concentrated stock and reinvest the proceeds in a diversified mix of investments. How much of your stock to sell depends on a number of factors. If it’s a stock whose best days appear to be behind it, you might consider selling it all and investing in more promising opportunities. But you’ll need to be mindful of the tax impact.
You could also consider using a direct indexing strategy to build a diversifying strategy around a concentrated position that can assist in reducing risk by investing the rest of the portfolio in stocks that complement the concentrated position and possess characteristics that offset some of the concentration-related risks. Setting precise capital gains realization budgets and using active tax-loss harvesting may help reduce those concentrated positions over time in a tax-efficient manner. Again, you would be further diversifying your portfolio and delaying a potentially significant tax bill.
Navigating the Tax Gauntlet
If your appreciated stock is held in a tax-advantaged account such as a 401(k) or traditional IRA, you’ll be able to sell without creating a taxable event as long as the money stays in the account.2 If it’s in a taxable account, tax-loss harvesting—banking realized losses from declining investments—may soften the tax blow. But there may be no way around paying at least some capital gains tax. Many investors with highly appreciated stock choose to sell gradually over the course of multiple years, making the tax consequences more manageable.
Collars and Covered Call Option Strategies1
Should you choose to maintain a concentrated stock position, certain option strategies can be used to help limit the damage from a significant price drop. A collar strategy, for example, involves buying a put option for downside protection and selling a call option to fund the purchase of the protective put. This creates a ceiling (limits upside appreciation) and a floor (reduces downside exposure) around the stock price (hence the name collar) to protect against large losses while incurring no up-front costs.
If protection is not the primary concern, then you can sell covered call options on your stock to tactically get out of a concentrated position over time while getting paid to wait for the stock to go to higher prices. Once it does, shares can be sold via the call options to reduce the concentration. The main drawbacks of a covered call strategy are the risk of losing money if the stock drops significantly and limiting upside appreciation.
Gifting to Loved Ones
Gifting shares from a concentrated holding to family members, whether directly or via a trust, is another way to reduce your concentrated position. It can also dovetail with estate planning by helping to reduce your taxable estate. One potential drawback of this strategy: While inherited shares of stock receive a step-up in tax basis, those that are gifted do not. Thus, the recipient may face capital gains tax obligations once they sell the shares. If the recipient is in a lower tax bracket than the individual giving the gift, however, there may still be a tax benefit.
Gifting to Charity
There’s an unquestionable tax benefit when stock is gifted to charitable organizations. The gift, whether made directly to a charity or to a donor-advised fund (DAF), is generally fully deductible in the year it’s made—up to 30% of the adjusted gross income of the individual giving the gift. With a DAF, you realize the tax deduction now; decisions about where to donate the money can be made later. Again, such gifts can serve an estate planning purpose by reducing the size of a taxable estate.
Charitable remainder trusts (CRTs) are one attractive option for those who are charity minded and need to manage concentrated stock portfolios. Once appreciated stock is contributed to a CRT, it can be sold and the proceeds used to construct a diversified mix of holdings. Not only can the donor avoid an immediate capital gains tax liability, but they can also receive an income stream from the trust for a designated period. At the end of the trust term, remaining assets are distributed to charities designated by the donor. CRTs can also be created after your death and the death of your spouse to provide an income stream to your children, with the remainder going to charity.
We’re Here to Help
Remember that strategies can be combined to achieve optimal results across investment objectives, tax planning and estate planning. In many cases, a multi-strategy approach can help clients diversify a concentrated position. For example, you might decide to gift to charity highly appreciated shares, possibly the ones you received earliest, while selling your least-appreciated shares, realizing the capital gain and using the proceeds to diversify.
At the same time, you might hold on to a moderately appreciated single stock in a managed account and build a diversified portfolio around it. You may also need to consider your time horizon. An individual who will be in a lower tax bracket when they retire may want to wait to sell their position so they can realize capital gains at a lower tax rate.
The best approach depends on your specific situation and goals. Don’t hesitate to contact your wealth advisor with any questions.
This article is being provided for informational and educational purposes only. It should not be construed as an individualized recommendation or personalized advice. The information and opinions provided have been obtained from sources deemed reliable, but we make no representation regarding the accuracy or completeness of the information. Please contact your financial, tax, and legal professionals for more information specific to your personal situation.
1Options involve significant risk and are not appropriate for all investors. Investors should carefully consider whether such trading is suitable for them, considering their financial condition and individual risk tolerance. It is also important that investors read the Characteristics and Risks of Standardized Options before investing in any options trading strategies. Options transactions are often complex and may involve the potential of losing the entire investment in a relatively short period of time. Certain complex options strategies carry additional risk, including the potential for losses that may exceed the original investment amount.
2Withdrawals from tax-deferred are typically subject to ordinary income tax and may be subject to a 10% federal tax penalty if taken prior to age 59½.
Diversification does not ensure a profit or protect against loss in a declining market. Investing involves risk, including the potential loss of principal, and there can be no guarantee that any investing strategy will be successful.
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