For employees of Fortune 500 companies who receive much of their compensation in equity, or for investors who have previously succeeded in selecting profitable stocks, concentration risk poses substantial challenges.
By recognizing the potential risks and taking steps to manage them, you may potentially strengthen your financial health with a more robust investment strategy.
Managing Concentrated Stock Positions for Long-Term Financial Success
For many investors, accumulating a large position in a single stock can be a double-edged sword. On one hand, concentrating your wealth in an asset that has historically performed well offers the potential for exponential financial growth.
On the other hand, investing in individual stocks carries substantial risks, notably the potential for permanent capital loss. When your financial well-being is closely linked to the performance of a single company, a significant drop in its stock value can have serious consequences for your financial security.
For employees of Fortune 500 companies who receive much of their compensation in equity, or for investors who have previously succeeded in selecting profitable stocks, concentration risk poses substantial challenges. By recognizing the potential risks and taking steps to manage them, you may potentially strengthen your financial health with a more robust investment strategy.
What Is Concentration Risk?
Concentration risk arises when an investor's portfolio is heavily weighted toward a single investment or a small group of investments, significantly increasing the potential for financial loss. This risk is notable because it directly ties the portfolio's value to the performance of just one or a few assets.
For example, suppose an investor has 70% of their wealth in a single company's stock. Any negative developments—such as poor earnings reports, leadership issues, or industry struggles—could lead to substantial financial losses.
In contrast, a diversified portfolio, which spreads investments across various sectors and asset types, is less susceptible to the negative impact of any single investment. Diversification allows the positive performance of some assets which could probably compensate for losses from others, thereby potentially stabilizing overall returns and possibly minimizing the risk of significant financial setbacks.
Addressing Emotional Attachments to Stocks
Diversification is indeed the antidote to concentration risk. However, before diving into specific strategies, it's important to acknowledge the emotional component that often accompanies long-held investments.
Stocks acquired through employment or early investment decisions may carry sentimental value, representing years of commitment and belief in a company's mission. Similarly, shares inherited from a loved one may be difficult to part with, especially if they had owned the stock for many years.
No matter the root, emotional attachments can cloud judgment, leading to investment decisions that aren’t in your best interest. These decisions can impede your progress toward financial goals and may even jeopardize your financial security.
If you’ve accumulated a concentrated stock position, it’s wise to first evaluate your attachment to the stock and consider how it may be affecting your outlook. Engaging with a wealth advisor can provide an objective viewpoint, offering clarity when making investment decisions.
Tax-Efficient Strategies for Diversifying a Concentrated Stock Position
While mitigating concentration risk is one element for long-term financial stability, a strategic approach is essential—particularly if your shares are in a taxable investment account. This is because capital gains taxes can diminish your earnings, hampering your future growth potential. Careful planning may potentially significantly reduce the associated tax liability and improve the overall outcome.
Strategy #1: Gradual Diversification
Gradually diversifying your portfolio can mitigate the risks associated with having too much wealth tied up in one company or industry. This approach allows you to manage the potential tax implications by strategically selling off portions of the concentrated stock over time and reallocating the proceeds into other assets.
The following strategies might enhance the tax efficiency of this approach:
- Timing the Sales. Selling shares in lower-income tax years may result in paying a lesser tax rate on capital gains. Additionally, spreading the sales across multiple tax years can prevent pushing your income into a higher tax bracket in a single year.
- Tax-Loss Harvesting. Selling underperforming assets to generate a capital loss can offset the gains you realize from selling shares of the concentrated stock.
- Comparing Cost Basis. If you acquired your shares at different times and prices, selling shares with a higher cost basis first can help minimize capital gains taxes.
- Reviewing Holding Periods. Holding shares for at least a year before selling them can reduce your overall tax liability since the long-term capital gains tax rate is generally lower than short-term capital gains rates.
Strategy #2: Equity Exchange Funds
An exchange fund, or swap fund, offers an innovative solution for managing concentration risk without the immediate tax consequences of selling a large stock position. This strategy allows multiple investors to contribute shares of highly appreciated stock to a single fund. In return, each investor receives a proportional share of the exchange fund, effectively diversifying their investment portfolio.
One advantage of using an exchange fund is the deferral of capital gains taxes. Whereas selling your shares outright can result in an immediate tax liability, contributing to an exchange fund allows you to defer paying capital gains taxes until you eventually sell your shares of the fund.
However, it’s important to note that exchange funds typically require a long-term commitment, often a minimum of seven to ten years, to fully realize the tax benefits and ensure the fund's stability. Furthermore, due to their complexity and associated risks, exchange funds are generally accessible only to accredited investors.
Strategy #3: Securities-Based Lending
Securities-based lending lets you use your concentrated stock position as collateral to secure a revolving line of credit. This strategy is attractive because it allows you to retain ownership of your shares, benefiting from potential dividends, interest, or capital gains. It also provides flexibility and access to funds that can be used for various purposes, such as purchasing real estate, funding a business venture, or managing unexpected expenses.
However, securities-based lending carries risks, particularly if the market value of your collateral—your concentrated stock position—drops below a certain threshold. In such cases, the lender may require additional collateral, or they might liquidate some of your holdings to satisfy the loan's collateral requirements if you can’t meet the demand with other assets.
Strategy #4: Borrowing on Margin
Compared to securities-based lending, margin borrowing offers a more direct approach to leverage your existing securities for purchasing additional investments. By using your concentrated stock position as collateral, you borrow funds directly from a brokerage to acquire other securities. This method enables you to diversify your investment portfolio without needing to sell your initial holdings.
However, similar to securities-based lending, margin loans come with considerable risks. A knowledgeable wealth advisor can help you evaluate the potential advantages and drawbacks of margin borrowing, ensuring this strategy is in alignment with your financial situation and objectives.
Strategy #5: Gifting Stock to the Next Generation
Another effective strategy for diversifying a concentrated stock position is to gift shares to the next generation or younger family members during your life. This strategy lets you transfer the stock on a low-cost basis out of your portfolio and the recipient would then be responsible for the taxability of the sale of the stock. Assuming they are in a lower tax bracket, the tax consequences would be lowered.
Under the current U.S. tax law, the recipient receives the stock at the original cost basis at the time of the gift. For example, if an investor purchased shares for $10,000 that are now worth $100,000, the recipient would pay capital gains tax on the $90,000. Assuming they are in the 22% tax bracket, they could pay up to 15% of the capital gains rate on the stock sale.
Strategy #6: Donating Appreciated Shares to a Donor-Advised Fund (DAF)
Donating appreciated stock to a donor-advised fund (DAF) is an option for investors looking to manage a concentrated stock position while simultaneously benefiting a good cause. This approach not only helps diversify your investment portfolio but also provides significant tax advantages, particularly if you’ve held the securities for more than a year.
When you donate appreciated securities that you've held for over a year, you avoid paying capital gains taxes on the increase in value from the time of purchase. You can also claim a charitable deduction for the full fair market value of the stock at the time of the donation (up to IRS limits, and assuming you itemize).
One option is to gift shares directly to a charity that accepts non-cash donations. Alternatively, donating your shares to a DAF enables you to take an immediate tax deduction in the year you make the donation while giving you the flexibility to make charitable grants over time.
Are You Carrying Too Much Concentration Risk?
Diversifying a concentrated stock position isn’t a one-size-fits-all strategy; rather, it requires a nuanced approach that balances emotional attachments, market conditions, and personal financial circumstances. Given the complexities and potential pitfalls involved, working with an experienced wealth advisor can be invaluable.
At EP Wealth, our clients include Fortune 500 executives, small business owners, and high-earning professionals, many of whom have amassed substantial stock positions as their success has grown.
Contact us for a complimentary portfolio review, where we can assess your concentration risk and identify tax-efficient strategies to diversify your assets.
DISCLOSURES:
- EP Wealth Advisors, LLC. is registered as an investment advisor with the SEC and only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements. SEC registration does not constitute an endorsement of the firm by the Commission nor does it indicate that the advisor has attained a particular level of skill or ability.
- Request an appointment with an EP Wealth Advisor when you have a minimum of $500,000 in investable assets – which includes qualified retirement plans (IRA, Roth IRA, 401(k), taxable brokerage, cash (savings / checking) and CDs. Investable assets do not include your home, vehicles, or collectibles.
- Hiring a qualified advisor and/or financial planner does not guarantee investment success, and does not ensure that a client or prospective client will experience a higher level of performance or results. No guaranty or warranty is made that any direct or implied results or projections being represented here will be met or sustained.
- The need for a financial advisor or financial planner and/or the type of services required are specific to the uniqueness of each individual’s circumstances. There is no guarantee or warrantee that the services offered by EP Wealth Advisors, LLC will satisfy your specific financial services requirements. Services offered by other advisors may align more to your specific needs.
- Information presented is general in nature and should not be viewed as a comprehensive analysis of the topics discussed. It is intended to serve as a tool containing general information that should assist you in the development of subsequent discussions. Content does not involve the rendering of personalized investment advice nor is it intended to supplement professional individualized advice.
- EP Wealth Advisors (“EPWA”) makes no representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information presented. All expressions of option are subject to change without notice.
- All investment strategies have the potential for profit or loss. Different types of investments and investment strategies involve varying degrees of risk, and there can be no assurance that any specific investment strategy will be suitable or profitable for a client’s portfolio. The risk of loss can never be eliminated even if working with a professional.
- The free financial health assessment referenced here is limited to, and can only be provided to, individuals with $500,000 or more in investable assets. The health assessment is limited to an initial call or meeting with an Investment Adviser Representative (IAR) of EP Wealth to discuss and assess your current financial situation and a subsequent follow-up meeting or call to share our thoughts. No additional services will be provided. EP Wealth Advisors’ obligation is limited to extending an offer to provide these services. It is the responsibility of the individual requesting the free health assessment to accept the service offered. No guarantee or warranty can be made that any of the information discussed or relayed in these meetings will be suitable or relevant. The free financial health assessment is limited in nature and is not intended to be regarded as an attempt to provide comprehensive financial advice.
- The information presented is hypothetical in nature and not reflective of a real client or scenario. There is no guarantee nor is the intention of this example to establish any sense of assurance, that, if followed, the strategies referenced here will produce a positive or desired outcome. In fact, there is no guarantee or warranty that any of the steps detailed will enable a positive outcome, successful or desired results. The intent of this hypothetical example is strictly for educational and illustrative purposes only.
