One individual stock should not make up more than 10% of your investment assets – the risk of something going wrong with that company and taking your financial goals down with it is simply too great.
But often as the result of a happy accident, maybe a gift or particularly winning investment from their past, people end up with a significant portion of their wealth invested in one single company.
People who have concentrated stock positions are often convinced they know the company and know that it’s a good/safe investment. But I always like to remind people there are plenty of examples of blue-chip companies that went out of business (e.g., Kodak) or took a huge hit (GE or Boeing). People investing in those companies never would’ve thought that would happen in a million years.
It is simply a risk you do not have to take, which is why we generally don’t recommend investing over 10% of your assets in one company. We don’t even suggest owning that much, that is just where we draw the line.
In qualified accounts (401k, IRAs, etc.) it is fairly straightforward (besides the emotional components) to sell the stock and buy a more diversified mutual fund or ETF.
However, if you happen to have a concentrated stock position with a low-cost basis in a taxable account, it may not be wise to sell it because it would create a lot of capital gains and result in a huge tax bill.
There are a few different ways to handle this issue:
Before we even talk about unwinding a stock position, it’s important to prevent a concentrated stock position from becoming an even bigger problem. If you have your investment account set up to automatically reinvest dividends in a concentrated stock position, make sure to change that. Instead, take the dividends from that stock in cash and reinvest them in diversified investments.
If you are relatively young, you may just want to sell the stock and eat the tax consequences because it’s going to be a long time before you will die and get a step-up in cost basis and you don’t want to maintain that amount of concentration risk for a long time.
To avoid creating a large capital gain in a single year, you can sell a portion of the individual stock over several years. This is an especially attractive option for those in the 0% capital gains tax bracket.
You can also try to do tax-loss harvesting to offset some of the gains in years where the market is down.
However, the risk with this strategy is that you’re remaining exposed to concentration risk for an extended period of time and could get crushed while you’re nibbling away at a huge position.
If you are older, you may want to hang on to it until you pass away. When you die, the stock will receive a step up in cost basis, which eliminates the embedded capital gain and will allow your heirs to unwind the position without creating taxes. If you pursue this strategy, you may want to use options contracts (the right to buy or right to sell a stock at a specified price) to hedge the risk associated with the stock during your lifetime.
First, you can buy a put option (the right to sell a stock a specified price) to set a “floor” on the maximum loss you could tolerate. Buying a put sets a floor on the downside, leaves unlimited upside potential, but can be costly.
This is not an all-or-nothing proposition - you could also hedge a part of the stock and leave part unhedged to reduce the cost but leave more potential downside.
To reduce the up-front costs of hedging your stock position with a put option, you can sell a “call” option (the right to buy a stock at a specified price). The premium you receive from selling the call partially (sometimes fully) offsets the cost of purchasing the put option. This strategy leads to lower up-front costs, but it limits your upside on the stock to the strike price of the call (which is a different type of possible cost). This strategy is called a “collar” because you’re essentially placing bands an upper and lower limit around the current stock price.
Another issue with a collar strategy is that the stock could get “called away from you,” meaning you have to sell the securities to the person who bought the call from you if the stock price rises higher than the strike price of your call option.
Creating options strategies to hedge your concentrated stock positions can be complex, and I highly recommend hiring a 3rd party to help you implement these strategies. There are companies that do that for a fee depending on the value of the position they are hedging. They monitor the likelihood of a call being called away from you and if it rises too high, they get rid of the call option. However, this creates an additional cost, which should be considered in your plans.
Contribute to Donor-Advised Fund & Sell the Stock
If you have significant charitable gifting intentions, you could consider transferring a portion of the stock to a donor-advised fund.
Any money you contribute to a donor-advised funds are tax deductible in the current year, but you can wait to donate the money to charity at a later date.
Once the stock is in the donor-advised fund, you can sell it without tax consequences and reinvest it in a diversified investment portfolio.
This strategy will also allow you to sell a portion of the remaining stock that same year because the tax deduction will help offset the capital gains created by selling the stock.
The best route for you may be a combination of these options.
For example, you could contribute some stock to a donor-advised fund, sell some stock each year for a number of years, and hedge the stock until it’s a small enough portion of your assets that you’re comfortable with.
Create a Plan and Stick to It
Whichever route you choose, it is important to create an actual plan for unwinding or hedging a concentrated stock position and stick to it.
Some of these options cost money and feel like money down the drain if all goes well with the stock price. It can be tempting to forego these strategies when the stock has been rising, which makes the whole thing break down.
If you feel you are unable to do this yourself, your gut instinct is probably right. It is often hard to make rational decisions when it comes to your own finances because investing and our personal finances have so many emotions tied to them. A financial advisor can help you overcome these emotions and create a plan of attack to unwind a concentrated stock position. Even more important, they can help you stick to that plan when it isn’t easy.
The easiest thing is always to do nothing, and whether you decide to do it yourself or seek the help of a professional, the most important thing is that you take action to prevent a potential financial pitfall before it has the chance to happen.