Methods For Mitigating Concentration Risk
“Don’t put all of your eggs in one basket”. This is one of the most common idioms in the English language. Whether it was loving advice from your grandparents, guidance from a friend, or a conversation with your coach or boss, we’ve all heard the warning. If you’re like me, these trite clichés can be annoying and easy to dismiss. The grass isn’t always greener on the other side, the early bird gets the worm, don’t bite off more than you can chew… yeah, yeah, we’ve heard them all a thousand times. However, as played out as these sayings might be, the reality is that they are packed with wisdom. Maybe that’s why they have beat these sayings into our heads since elementary school.
Since you’ve heard the phrase “don't put all of your eggs in one basket” your entire life, you don’t need me to explain the meaning. However, I think it’s critically important to apply this phrase to your investment portfolio. What we call ‘concentration risk’ in the investment world is the direct equivalent to putting all your eggs in one basket. Concentration risk is the risk of severe losses that could occur if an investor has all, or a large portion, of their money invested in a single stock, industry, or market sector. Why is concentration risk such a big concern? Let’s put some numbers to it. The average annualized volatility of the underlying stocks that currently make up the S&P 5001 is 30.81% over the past 5 years, whereas the average annualized volatility of the S&P 500¹ index itself is 15.63% over the past 5 years. Essentially, the average individual stock in the S&P 500 is roughly twice as volatile as the index itself. This data shows us that the average individual stock is more prone to significant price swings than a diversified portfolio of hundreds of stocks is. Additionally, it’s not out of the realm of possibility that any individual company goes bankrupt, ceases to do business, or simply fails to keep up with changing economic environments. This can cause a company’s stock to plummet dramatically or even be permanently reduced to $0 (think Enron, Blockbuster, Sears, Kodak, RadioShack). By diversifying our investment holdings, we can eliminate concentration risk and greatly reduce the probability of significant, permanent market losses.
Depending on who you talk to, a financial professional is likely to say that any individual stock position in excess of 5-10% of your total portfolio value bears concentration risk. We find that many investors who work for companies that offer stock options, restricted stock units, employee stock purchase plans, and other stock grant programs are some of the most likely to have concentrated stock positions. Having a portfolio that is highly concentrated in your employer’s stock is the epitome of putting all your eggs in one basket. Not only is your investment portfolio tied to the success of your company, but so is your paycheck. If your company encounters turbulent times (or even worse, goes under), not only is your investment portfolio at risk, but so is your job security and income. Therefore, the need to diversify out of concentrated holdings in employer stock is even more paramount. The obvious question is then, “what are my options for diversifying out of employer stock?”. And because we know nothing in the investment world comes without risk, tax, and liquidity considerations, a logical subsequent question is, “what are the potential ramifications of these diversification options?”. Luckily for you, we’re here to answer those questions!
Your options will vary depending on if your concentrated stock is held within a tax-advantaged account (401(k), IRA, Roth, etc.) or if it is held in a taxable account. I’ve largely ignored tax- advantaged accounts such as Roths and 401(k)s because the answer is simple; if you find yourself with a concentrated stock position in a tax-advantaged account you can easily diversify out of it with no tax impact or liquidity constraints. However, there is one consideration for company stock holdings held within traditional 401(k) accounts that I’ll address at the end of the article. The focus of this article is primarily on diversification in taxable accounts. Keep in mind these strategies are only applicable for concentrated stock positions in publicly traded securities. There are other, more nuanced, approaches for concentrated positions in private business that we’d be more than happy to discuss with you separately.
Diversification Strategies for Taxable Accounts
1. Sell Concentrated Position
The most obvious strategy is simply to sell some or all of your concentrated position and reinvest the proceeds in a more diversified manner. However, the main drawback is that selling the stock will likely result in capital gains taxes. Tax liability is certainly the biggest hurdle that prevents people from taking this action. While we understand that paying taxes is painful, we have to weigh the tax implications against the concentration risk of the position. What’s more painful: incurring a 15-20% capital gains tax on an appreciated position or hanging onto the position and potentially having that stock plummet in value or go to zero? If you simply can’t stomach incurring all that capital gains tax at one time, you can explore the following:
Create a liquidation schedule over a multi-year period to spread the tax burden across multiple tax years.
If your taxable income varies widely from year to year (heavy commission-based employment, business owner, etc.) delay the sale of the stock to a year in which your income is lower than average. This might reduce the capital gains tax rate you would pay relative to one of your higher earning years.
Look for tax-loss harvesting opportunities in your portfolio. If you sell other stock positions at a loss, those capital losses can be offset against the gain on your concentrated position, reducing your net tax burden.
2. Build a Completion Portfolio
This option is only viable for individuals who have significant excess income and a high propensity to save/invest. For these individuals, the concept of a completion portfolio is simple: invest excess cash into diversified portfolio holdings until your concentrated stock position now represents less than 10% of your total portfolio value. This strategy is great for high income earners because they can diversify away their concentration risk without having to sell the original concentrated position. It’s the best of both worlds: you remove concentration risk from your portfolio, and you don’t have to incur any capital gains taxes to do it!
3. Consider Charitable/Gifting Strategies
Concentrated stock positions are ideal candidates for gifting to charity or to children/grandchildren.
Gifting stocks to charity is a tax-free transaction to you. Additionally, if you itemize your tax deductions, it’s likely you will be able to deduct some or all of that charitable stock gift. All the embedded gains in that stock are now transferred to the charity and, if that charity qualifies as a tax-exempt entity (as many do), the charity won’t have to pay any tax on the sale of that stock. You can gift stock directly charities or you can explore setting up a Donor Advised Fund (happy to chat through DAFs separately). There is no limit to the amount of charitable gifting you can do each year.
You can also gift stocks to individuals. Most commonly we see stocks gifted to children and grandchildren, but you can also gift to an extended family member or friend. Unlike with charities, the embedded gains in the position would now be transferred to the recipient who is now on the hook for any potential capital gains taxes if they choose to sell. This gift can often be tax-free to you, however, there are limits for the amount you can gift to individuals tax-free so be sure to have a discussion with a financial professional before gifting.
All of this assumes that you have additional resources to fund your lifestyle. Obviously by gifting a concentrated position to charity or family, you are parting ways with those assets forever. If you’re counting on those assets for personal use, then gifting them all away is certainly not ideal. However, there are various charitable mechanisms through which someone can do a tax-free gift of stock yet retain some interest in the value of those stocks. One of the most common methods is to set up a Charitable Remainder Trust (CRT). I could write a whole article on how CRTs function, but the basic premise is this: you gift the CRT your concentrated stock position (tax-free), the CRT can then reinvest those securities however it sees fit, the CRT pays you income throughout the life of the CRT, the securities in the CRT are donated to a charity of your choice upon the termination of the CRT. This is a way to remove a concentrated stock from your portfolio, provide yourself with an income source for an extended period of time, and give to charity all in one!
4. Exchange Funds
These are funds sponsored by large financial institutions such as banks or asset managers. They allow investors to contribute their concentrated stock positions to the fund. This transaction does not incur capital gains tax. Each investor then receives an interest in that fund based on the size of their contribution. After each investor has contributed their stocks to the fund, the fund now holds a relatively diversified basket of securities. Once the fund closes, you receive a pro-rata portion of all the underlying stocks that are owned by the fund. Capital gains taxes are incurred once and if you decide to sell any of the stocks that are returned to you. Essentially, you are exchanging your concentrated stock position for a more diversified basket of stocks.
However, there are some downsides:
Exchange Funds typically have a lock-up period of 7 years. Meaning, you cannot access these assets for personal use until the lockup period is over. Before utilizing an exchange fund it’s important to ensure you have ample liquidity from other resources to fund your lifestyle for the next 7 years.
Exchange Funds usually have significantly higher expense ratios than other diversified investment products such as mutual funds and exchange traded funds.
You have little to no control over what securities you will receive at the end of the lockup period. While you will most certainly have a more diversified basket of securities at the end of the 7 years, the quality of those securities depends on what stocks the other investors initially contributed to the fund and how the fund was managed over its life.
Net Unrealized Appreciation (NUA) in 401(k) Accounts
I mentioned earlier that if you hold a concentrated position in employer stock within your 401(k) account, you can easily diversify out of it by selling it within the 401(k) and reinvesting in other more diversified options within the plan. This action triggers no immediate tax impact. In most cases, this course of action would be our recommendation. However, there can be circumstances in which that course of action might not make sense. That exception usually applies to folks who are close to retirement and have large gains in their company stock.
When you take a distribution from your 401(k) it is taxed at ordinary income tax rates. For the vast majority of individuals, ordinary income tax rates are higher than long term capital gains tax rates. The NUA rule allows an individual who owns employer stock within their 401(k) plan to have a portion of that stock taxed at long term capital gains rates rather than ordinary income rates upon distribution from the 401(k). Thus, the NUA rule can provide a tax benefit.
How It Works
The cost basis (what you originally paid for it) on the stock is taxed at ordinary income tax rates upon distribution. However, the appreciation on the stock will be taxed at long term capital gains rates (assuming you’ve held it for more than 1 year) only if/when you decide to sell that stock.
For example: Let’s say you have 1,000 shares of company stock in your 401(k) with a cost basis of $10 per share (what you paid for it). The current market value of the stock is $60 per share.
The cost basis is $10,000 (1,000 shares x $10 per share).
The NUA is $50,000 (1,000 shares x ($60 - $10) per share).
When you take a lump-sum distribution of the stock, the tax treatment would be:
You pay ordinary income tax on the $10,000 cost basis (the amount you originally paid).
You pay long-term capital gains tax on the $50,000 NUA when/if you sell the stock.
Had you taken a regular $60,000 distribution from your 401(k), the entire amount would be taxed as ordinary income.
While this tax treatment might seem enticing, don’t let it steer you towards investing the bulk of your 401(k) in employer stock. In most cases, it’s likely that the preferential tax treatment does not outweigh the risk of being overly concentrated in employer stock. However, NUA can be a great lever to pull if you are someone who has already accumulated a large stake in employer stock and is nearing retirement.
Ensuring your wealth isn’t overly concentrated in one particular stock might be the differentiator between a successful retirement and financial calamity. While the task of diversifying might seem daunting or too riddled with taxes, it is certainly a worthwhile and achievable endeavor with the appropriate guidance. If this article resonated with you and you’d like to have a conversation regarding your concentrated stock holdings, please don’t hesitate to reach out.
Myself and the rest of the team here at Scratch Capital are more than happy to assist.
Please keep in mind that this is not an exhaustive list of potential solutions. Additionally, the suitability of these various strategies differs from person to person based on a host of factors relating to their personal financial situation. Please speak with a financial professional to determine if these strategies make sense for you.
Derek Jones, CFA, CAIA, CRPSTM
Financial Advisor
Source
¹S&P 500 and underlying holdings represented using VOO – Vanguard 500 Index Fund ETF and its underlying holdings
