Key Takeaways
One silver lining to today’s highly volatile bear market – great planning opportunities.
If an individual stock accounts for 10% or more of your overall portfolio – or more -- you’re susceptible to concentration risk, no matter how great a company it is.
It can be hard to sell company stock that you (or your family) have owned for years, but that loyalty can potentially come back to bite you.
Whenever new clients join us, one of the first things we discuss with them is “what matters” vs. “what we can control.” While it’s upsetting to see the stock market decline sharply, we know the market delivers high positive returns over the long-term. However, those returns are random; we can’t control exactly when the market goes up or down and by how much. A better idea is to focus on what we can control.
Take concentrated stock positions, for example. With so much volatility in the market, and asset values declining, now can be a good time to reduce a concentrated stock position that you may have built up over the years from either company stock you’ve received from your employer – or inherited from family -- over the years.
Whenever you have a single stock making up a significant portion of your portfolio – say 10% or more – you’re exposing your portfolio to lots of “concentration risk” if that stock suddenly stops performing. I know it’s hard to think about selling company stock when you’ve been affiliated with that organization for many years. But by holding on to it forever, without reducing your position from time to time, you’re effectively taking on too much risk by not having a sufficiently diversified portfolio.
We’ve found this reluctance to sell company stock can be just as strong for those who’ve inherited the stock as for those who received it as an employee.
One Novi client inherited IBM stock from her parents and has held it for 50 years. Her parents always told her: “It’s a great company. Don’t ever sell it.” She’s fortunate in that IBM has performed well most of the past century, but since our client received those shares at such a low-cost basis, and since it accounts for such a large chunk of her portfolio, it has limited her and her spouse’s financial planning.
We have another client who inherited a large chunk of Proctor & Gamble stock when his parents died in the 1980s. Until we started working with him, his portfolio took a huge hit every time P&G went down. Yet he faced big capital gains because the stock had appreciated so much from when he received it in the 1980s. Over time, we helped him reduce his P&G holdings when the stock dipped and that greatly helped his tax situation, giving him a better-balanced portfolio.
Whether received through inheritance or company grants, people tend to develop emotional attachments to company stock. They don’t want to let down their family (or employer) by selling it, even if makes them susceptible to concentration risk and large capital gains down the road. This emotional bias can also be clouded by “familiarity bias” in which they’ll overlook a concentrated stock’s sub-par performance because they think they know the company and the industry so well and believe it’s always been a “great blue-chip company.”
4 tips for reducing concentrated stock positions
1. Sell concentrated stock while the market is down. Your tax impact is much lower and you benefit from the rebound by being in a diversified portfolio. One couple we know had a $5 million portfolio until the mid-2000s. On the surface they were in great shape, but we soon discovered that all their wealth was allocated to just eight individual stocks. Granted, each of the stocks were in blue-chip companies, but they weren’t very diversified. As a result, they took a bath during the 2000 tech crunch and came to us asking: “What should we do?” During the 2008-09 financial crisis the market was down sharply again. We used that bear market as an opportunity to sell the majority of their large positions at a lower price, which greatly lowered their lower tax impact. We reinvested all the cash proceeds from those stock sales into a properly diversified portfolio of stocks. Their newly diversified portfolio benefited from the ensuing market boom and they are in a much better financial position going forward. By the way, if a married couple decides to retire early – i.e., before taking Social Security or receiving pension income – their tax rate will be extremely low. In 2022, the long term capital gains rate for married couples filing jointly is 0% for the first $83,350. This means you can sell $83,349 of stock with $0 as the cost basis and pay no taxes.
2. Loss harvesting. In a year like 2022 when markets are down over 20%, if you invested cash recently, chances are you have some losses you can “harvest.” If you invested $1 million dollars of cash at the beginning of the year, you could likely harvest around $200,000 in losses this year. That means you could sell $200,000 worth of gains on your concentrated stock positions, pay no taxes on those gains, and reallocate the proceeds into a well-diversified portfolio.
3. Utilize an exchange fund. An exchange fund — also called a swap fund — allows you to substitute or replace a concentrated stock position with a diversified basket of stocks of the same value, thus reducing portfolio risk and putting off tax consequences until later. An exchange fund (not an ETF) is essentially a limited partnership made up of a small number of investors who have similar concentrated stock positions. Typically, a large bank, investment company, or other financial institution will create the exchange fund and manage the holdings. Participants in the fund contribute some of the concentrated shares they hold, which are then pooled with other investors’ shares. With each shareholder that contributes to the fund, the portfolio becomes increasingly diversified.
For example, you may opt to contribute your large position of J&J stock. Someone else will contribute their concentrated Pfizer stock and someone else will contribute their concentrated Google stock into the pooled fund. After a certain period of time, say five to seven years, you receive several stocks back in exchange for the one stock you put in and so you have reduced the overall risk of your portfolio. The downside to this strategy is that you still have low cost-basis in your stock, your access to the stock you contributed is limited, and the fees associated with the pooled fund can be high. An exchange fund is a strategy to consider, but isn’t appropriate for all situations. It depends upon your personal circumstances and goals.
4. Create an options “collar” to protect the value of a concentrated stock position temporarily. A “collar” position is created by buying (or owning) stock and by simultaneously buying protective puts and selling covered calls on a share-for-share basis. This limits your upside potential, but protects your downside if you plan to gift the stock to charity in the near future, or if you are unwell and wish to leave the stock to your heirs so they receive the step-up in cost basis to the current value. The options collar can be very helpful for the elderly, or for other high net worth individuals who are in poor health or who are simply undergoing some estate planning.
Conclusion Company stock can be a great way for employees and their families to share in the prospects of a company. Just know that such rewards come with a planning obligation. These are just a few ideas to deal with concentrated positions. If you or someone close to you has concerns about a large concentrated stock position in their portfolio, please don’t hesitate to reach out. We are happy to review it for you.
RYAN M. VOGEL, CFP® is the CHIEF PLANNING OFFICER, PARTNER at Novi Wealth