Too much of anything can be bad, at least in theory. But can too much company stock be a drawback—especially when the stock in question has done well and still seems like a good investment going forward?
Employer-granted stock awards and stock-purchase programs are two common ways to build up a concentrated stock position, which is typically defined as making up more than 10% of a portfolio’s total value. But building up a significant stake in one company’s stock, whether due to “own company” bias, paralysis to sell due to potential tax consequences, or sheer inertia on the employee’s part, can be a problem many investors don’t even realize they have until it’s too late.
Regardless of the means of accumulation, concentrated positions can be dangerous, primarily because too much of one company’s stock will throw off the balance of a diversified portfolio of equities, fixed income, and alternatives. If diversification makes for shock-resistant investment portfolios, concentration does the opposite. Even within the limits of prudent diversification in line with a client’s age, risk tolerance, and overall financial situation, holding too much of a single stock can be perilous for a variety of reasons, including:
Liquidity risk. Here “liquidity” is another word for “salability.” It’s short and easy work to sell a popular stock. But if it’s traded infrequently, or if it’s privately held, unraveling the position in the name of optimal diversification will take time and planning.
Tax-liability risk. Some investors will model the tax bill from selling a low-basis stock that has increased in value and decide they don’t want to take the hit. But kicking that can down the road may impact successful portfolio management. Major declines can happen to any company, no matter how popular or “safe” it might seem to be. With preferential long-term capital gains tax rates, it often makes much more sense to sell a portion over time to offset the impact of selling all at once. Tax planning comes into play big-time here: To some degree you can control the tax impact; what you can’t control is the value of the stock and its fluctuations.
Opportunity risk. A concentrated position and the bias that can sometimes accompany it may mean missing out or ignoring other investment opportunities, thereby limiting upside, or by not providing important protective diversification.
Then there are risks to concentrated positions largely beyond one’s control, including political, legislative, and regulatory changes, all of which can have a significant effect on a concentrated investment.
Sell when feasible. That’s why, in our view, it is both prudent and efficient for those who receive stock awards through their employer, or as a key employee or executive, to sell and diversify from their holdings as soon as they are able, when feasible.
Take restricted stock units (RSUs) as an example. When shares vest (become sellable) to the employee, the brokerage firm will typically withhold a portion of the shares and sell them to cover the taxes due. This means the remaining shares are now owned by the employee to do with what they will. If the employee were to sell the remaining shares, barring any major fluctuations in the stock price that day, the employee is essentially locking in the value of the awards without any more major tax consequences. The proceeds can then be reinvested in a diversified portfolio, thereby reducing the overall level of concentration.
For employees who have large portions of unvested stock or exposure to the stock in other ways, this can be a prudent way to minimize the tax impact and achieve diversification of the shares they have “control” over.
Mental accounting. One of the biggest barriers to managing a concentrated position is the client’s attachment to the stock. Investors often feel tied to shares they’ve been granted—and feel strongly about concentrated holdings they’ve selected themselves— especially if the holdings have gained greatly in value or have a “blue-chip” reputation for solid performance over time.
This is sometimes referred to as “mental accounting,” a behavioral bias that involves an investor having different feelings about different investment holdings according to their source or origin. It’s a bias common to employees who own their employer’s stock. When a portion of an employee’s compensation takes the form of stock awards rather than cash, misplaced loyalty or inertia can lead some employees to leave their vested company stock in brokerage accounts, largely unmanaged and accounting for an ever-growing proportion of their overall wealth.
Alternative routes. Yet, holding a concentrated position isn’t always a drawback. Financial planners have devised several time-tested strategies for blunting the negative impacts of a concentrated position—including monetization, hedging, and gifting—which, if well managed, can support both long- and short-term goals while eliminating some of the risks associated with having too many precious eggs in just one basket.
Hedging. Rather than selling the position, using an options strategy or customized structured notes tied to the same company can provide downside protection or even provide income on the position, all while allowing the client to potentially defer the sale and eventual tax implications. There are also more complicated hedging strategies including the use of exchange funds and opportunity zone funds (though opportunity zones have diminished in availability a bit).
Gifting. Charitable giving provides tax benefits for appreciated property, including stocks and other securities. Rather than selling shares to generate cash for a charitable gift, contributing appreciated stock directly to the organization bypasses any trigger of capital gains tax. Neither the person nor the receiving charity pays capital gains tax at sale, while the donor receives a deduction for the gift. Using a donor-advised fund can provide even more flexibility around donations. The benefit of a donor-advised fund allows the donor to make the gift now, but choose the amount, timing, and the eventual recipient later. If a client is charitably inclined and would benefit from the tax advantages of gifting property, but does not have a strong sense of what charity or charities they are looking to support, a donor-advised fund can provide a great solution. The drawback, however, is once property (cash or otherwise) is gifted to the DAF, it cannot be taken back and is removed from the personal assets and estate of the donor.
Aaron Marks is founding partner and CSO of Amplius Wealth Advisors. Previously, he was a financial advisor at Merrill Lynch starting in 2011, where he focused on a holistic wealth planning process for a select number of clients throughout the U.S. Most recently, Marks co-led The Liebman Marks Group.