As we mentioned in a previous article, successful executives who participate in various executive compensation plans can sometimes find themselves in the position of having a large percentage of their net worth concentrated in company stock units or stock options. This becomes even more critical as they move toward retirement and face the need to build a diversified asset base to provide for a secure and satisfying retirement lifestyle.
But executives nearing retirement aren’t the only ones susceptible to concentration risk. Employees in companies that execute IPOs, investors with long-term holdings in a stock with reinvested dividends, or even those who’ve bought and held a favorite stock that has grown beyond expectations can all experience exposure to concentrated stock risk (sometimes called “single-stock risk”).
Fortunately, “risk” isn’t the whole story with a concentrated position; there are also opportunities to be had. But taking advantage of them requires a bit of careful planning around taxes, current income, and other considerations.
How do concentrated stock positions develop?
1. The “Forever Hold” Dividend Stock
Some investors hold onto blue-chip dividend-paying stocks for decades, living off the income they generate. This was once a common retirement strategy—buy shares in a company like AT&T or Exxon, collect the dividends, and never sell. Over time, that stock can become a disproportionate share of your portfolio, leaving you vulnerable if the company’s fortunes change.
2. The Beloved Stock That Kept Growing
Sometimes it’s a company you admire—Apple, for example—that you buy and hold because you believe in its future. Years later, your investment has grown so much it’s now 20% or more of your total portfolio. Selling means realizing large capital gains, so many investors opt to hold, increasing their exposure to company-specific risk.
3. Inherited Shares
When you inherit stock, you generally receive a step-up in basis, meaning you can sell right away with little or no tax impact. But some people hold onto inherited shares for sentimental reasons. While keeping a small portion can make sense, letting a large inherited position dominate your portfolio can create unnecessary risk.
4. Employer Stock Accumulated Over Time
Even without an IPO windfall, long-term employees sometimes accumulate significant shares through executive compensation, stock options, stock purchase plans, or bonuses. If the stock performs well, that position can grow faster than the rest of their portfolio.
How concentrated is too concentrated?
When one stock makes up a significant percentage of your portfolio—10–20% of total investable assets, according to many advisors—it creates concentrated risk. Unlike a diversified portfolio, where performance is spread across different companies, sectors, and even countries, a concentrated position ties a large portion of your wealth to the fate of a single company.
The danger is that no matter how strong or stable a business may seem, individual companies can face unexpected setbacks. Management changes, new competitors, industry disruption, regulatory challenges, or economic downturns can all cause stock prices to fall, sometimes dramatically and with little warning. For investors heavily concentrated in such a stock, the losses can be devastating—even unrecoverable, unless they have decades to rebuild.
It’s also important to consider opportunity cost. While your concentrated stock is tied up in one company, you might miss out on gains from other sectors or regions that are performing well. Over time, a lack of diversification can result in lower overall returns and a more volatile investment ride.
What about the tax implications of a concentrated position?
Some might be thinking, “Why not just sell some or all of the stock and re-invest the proceeds?” That’s certainly a wise objective, but an efficient concentrated stock diversification strategy must take into consideration the tax implications of liquidating the stock. Remember: when stock is sold at a higher price than where it was purchased, capital gains tax is owed on the increase in value. For example, if an executive who has accumulated several thousand shares’ worth of highly appreciated company stock over a long career decided to sell all the stock at once, the difference between her cost basis and her sale price could be quite significant. Even at the lower tax rate generally available for long-term capital gains, she could owe thousands in taxes, just on the sale of the stock.
Are there tax-aware ways to diversify appreciated stock?
Fortunately, there are several strategies available for diversifying a concentrated position. Many investors adopt a plan of gradually selling the stock over a period of several years, allowing them to spread the capital gains burden over time as they re-invest the sales proceeds in a more diversified portfolio. Sometimes, they can take advantage of years when they are in a lower marginal bracket to reduce the amount of total tax paid on capital gains from the sale of the concentrated stock.
For those who inherit a concentrated stock position, it may be best to liquidate some or all of the position soon after receiving it, since most inheritors will get a stepped-up cost basis (typically, the value of the stock at the date of the ownership transfer). If the stock is sold soon thereafter, there may be little or no price movement, potentially resulting in a tax-neutral transaction.
Persons with philanthropic goals may opt to reduce a concentrated position by donating appreciated stock, either directly to a charity or using a donor-advised fund. This can be a tax-smart way to reduce concentration: they avoid paying capital gains tax, the charity can sell the stock tax-free, and the donor receives a charitable deduction.
In all cases, it’s important to talk to your trusted investment and tax advisors when deciding the best way to unwind a concentrated position. At The Planning Center, we work with clients to develop personalized plans for reducing concentrated risk. If you have questions about this or some other important financial matter, we can help.
