Over the years, you may have inherited a large holding, exercised options to buy your company’s stock, or benefited from repeat stock splits over the years. These scenarios (and more) can result in concentrated stock positions, which carries unique challenges and can be quite risky.
This is why it is a good idea to do some financial planning and take steps to diversify your stock position. In this article, we’ll discuss the unique sets of challenges - and opportunities - that can result from a concentrated stock position.
Why Is Concentrated Stock a Risk?
Concentrated stock positions are risky for several reasons. If you have a lot of wealth aggregated in one stock and that company goes bankrupt, the stock value would go to zero. Understandably, this scenario would severely diminish your savings and financial standing.
Less obvious is the risk that the company underperforms for a prolonged period of time. Obviously, this is not as devastating as a company going bankrupt. However, it still makes the stock holding a liability when the whole purpose of a stock holding is to be a value-generating asset.
There is also the issue of liquidity risk. Because there is a lot of volatility in owning a single stock, you have no guarantee of your stock’s worth if you need to sell the shares to get cash. With a diversified portfolio, you can sell the stock with the highest value, but if you have all your eggs in one basket and the stock value is low when you need it, you’re at a loss.
Finally, if you work for a company in which you have a large stock holding, you are putting yourself at double risk. If the company underperforms or goes under, your job could be at risk at the same time as your stock is losing value.
Why Investors Don’t Sell
Despite all of these risks associated with concentrated positions, there are many reasons why investors choose to stick with their portfolio as-is.
One reason is that they assume that the future will mirror the past. Some investors believe if a company has been successful and the stock has had a high value in the past, the same will apply to the future. However, this is a logical fallacy because companies face decreased performance or bankruptcy all the time as the market evolves.
Be careful about selling all your shares at once, as it is tough to time the market and maximize your return. ”
Another reason could be that they are employees of the company where they hold a lot of stock and are overconfident in their performance. If they have had success at the company, they may feel attached to the idea of maintaining a large stake in their business. This can cause them to believe that their success will correlate to the long-term value of the stock.
Another reason is that they fear stock prices will rise after they sell. It can be tricky knowing when to sell stock; many of us have been advised not to abandon an investment just because it has hit a rough patch.
That being said, when you have a concentrated stock position, you are putting yourself at a greater risk. Although your fear may be true, and the stock value could rise after you sell, you can reap the same benefits by diversifying your stock holding and minimizing your risk.
Strategies for Dealing With Concentrated Stock
There are many things to consider when deciding the best route for dealing with your concentrated stock position. Here are some of your options.
Sell your shares
Selling your stock may be one of the more simple ways to reduce your concentrated stock position. However, if you have a low-cost basis, you need to be careful about capital gain taxes and avoid any perception of market manipulation or insider trading.
You also need to be careful about selling all your shares at once, as it is tough to time the market and know when to maximize your return. To combat that risk, it is a good practice to spread the share sales across time and execute selling at different price points - that way, you’re making a series of small bets instead of one large bet.
Exchange your shares
There are always going to be investors who have concentrated stock positions. The exchange fund method takes advantage of this fact by allowing several investors to pool their funds into a partnership, with each partner receiving a pro-rata share of the exchange fund.
This allows for diversification. Each investor now owns a share of a fund that contains a portfolio of different stocks. With exchange funds, taxes are postponed until you sell the shares. You pay taxes on the difference between the value of the stock you contributed and the price received for your exchange fund shares.
There are some constraints to exchange funds. Individuals must be a Qualified Purchaser, which means they must have $5M in investable assets. There is typically a lock-up period of seven years, meaning individuals cannot access their portion of the fund until after seven years.
There is also the risk that your original stock will outperform the fund, and you are stuck with the fund value. This is rare, however, and it is best to minimize your risk by diversifying.
Monetize your position
You can have immediate liquidity by using a prepaid variable forward agreement. With this transaction, an investor with a concentrated stock position agrees to sell their shares at a future date in exchange for a cash advance at the present date.
You receive most of the shares’ value - typically 80-90% - when the agreement is signed. You are not, however, obligated to turn over the shares or pay taxes on them until the PVF’s maturity date. Once that date arrives, you must either settle the agreement by making a cash payment or turning over the appropriate number of shares, which depends on the stock’s price at that time.
Until then, your stock is held as collateral, and you can use your cash advance to buy other securities to diversify your portfolio.
Hedge your position
There are multiple ways to manage your risk by using options. You can buy a protective put, which puts a floor under your shares’ value by ensuring that you have the right to sell your shares at a predetermined price.
This will allow you to limit potential losses on the equity while still allowing you to participate in any potential appreciation. However, if the stock price remains above the put’s strike price, you end up losing money on the option itself.
You can also sell covered calls with a strike price above the market price. This can provide additional income from your holdings to offset potential losses if the stock’s price drops. This option limits the extent to which you can benefit from any potential price appreciation. If the share price reaches the call’s strike price, you have to be prepared to meet that call.
Charities benefit from gifted stock by selling the stock with no taxes paid because of their non-profit status.”
A collar is a combination of buying protective put options while selling call options whose premiums offset the costs of buying the puts. Like a covered call, the upside appreciation for your holding is limited to the call’s strike price. If that price is reached before the collar’s expiration date, you would not only lose the premium you paid for the put, but you would also face capital gains tax on any shares you sold.
You must also be cautious about closing one side of the collar while the other side of the trade remains outstanding. For example, if you exercised the put, but the shares you sell are later called away before the call’s expiration date, you could be left with an uncovered call. That means you could suffer a loss if you had to repurchase the shares at a higher price to fulfill the call.
Gift to charity
There are several charitable ways you can diversify your stock position. One way is through the direct gifting of stock, where you reduce your stock position by donating stock instead of cash. You will then be eligible for an income tax deduction for the stock's full market value, up to 30% gross income. This is a win-win because you reduce your position and capital gain exposure, and the charity benefits by selling the stock with no taxes paid because of its non-profit status.
You can also donate to a charitable trust structured with various gifting strategies. One type is the charitable remainder trust (CRT). This provides gifting opportunities while creating tax benefits. The trust can also typically sell the stock without paying capital gains taxes and reinvest the proceeds to provide an income stream to you as the donor.
Another type is a charitable lead trust (CLT), which is the opposite of a CRT because the charity receives the income stream for a specified time frame; the rest goes to your beneficiaries
There are also donor-advised funds (DAFs), in which the donor can fund the DAF with stock and potentially receive tax deductions for the value of the stock at the time of funding. The stock is sold, and the proceeds are then deposited into investment pools that the investor controls.
The investment choices are diversified pools of stocks, bonds, and money markets, allowing the investor to grow the account. When the investor is ready, they give the DAF the green light to liquidate funds from the investor pools to the charities of their choice.
Consult a Financial Advisor About Your Stock Portfolio
If you find yourself in a concentrated stock position and want to diversify your portfolio, you have options. There are short-term and long-term ways to adjust your standing and be more comfortable with your investment.
Just remember: the first step of any process should be to talk to an authorized financial advisor. They can offer you personalized investment advice and find an approach that meets your goals.
Non-deposit investment products and services are offered through CUSO Financial Services, L.P. ("CFS"), a registered broker-dealer Member FINRA/SIPC and SEC Registered Investment Advisor. Products offered through CFS: are not NCUA/NCUSIF or otherwise federally insured, are not guarantees or obligations of the credit union, and may involve investment risk including possible loss of principal. Investment Representatives are registered through CFS. The Credit Union has contracted with CFS to make non-deposit investment products and services available to credit union members.
Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2018.