February 2023
Everyone knows the saying don’t keep all your eggs in one basket. The solution to this—diversification— isn’t always so simple to accomplish. Many executives have ownership requirements for the stock of their companies and are forced to keep large quantities of their holdings. Corporate insiders often possess material nonpublic information, which adds the risk of insider trading if they sell shares.
Additionally, under company rules, you may have very short open trading windows when you are able to sell your stock. Sometimes, behavioral finance kicks in and loyalty to the company and overconfidence in its future may make it hard for executives and employees to diversify out of their company stock.
However, many strategies do exist to mitigate the risk of a concentrated stock position and add diversification to a portfolio. There are varying approaches, from simple to complex and from short- to long-term. I am going to briefly go over a few at a high level but it is always important to contact a professional for more information and to see what might be right for you.
While it’s hard to define what a concentrated position is, most advisors agree that any single position that’s worth over 10% of a portfolio is a dangerous concentration. What makes it so dangerous is that sudden stock losses often do not involve internal or business reasons within a company’s operations. Look at Netflix, down 50% from its peak, Zoom down 80%, and Zillow over 80%. These companies had no specific issues causing their rapid declines. Instead, it was due to macroeconomic factors like the war in Ukraine, the pandemic, and supply chain issues.
The simplest strategy for a dangerously concentrated stock position is to sell the shares and diversify. However, many people may be averse to selling their shares because of combined federal and state tax rates on capital gains that can approach 40%.
Another simpler strategy is gifting the stock. A gift of stock, no matter the size, is not taxable income, meaning no capital gains are paid, and the recipient can benefit for future growth of the stock. Depending on the size of your estate at death, a strategy of making lifetime gifts can reduce your estate taxes, and you could also consider the use of a GRAT or other estate planning techniques involving trusts. A similar and popular approach is stock donations, including the use of a charitable remainder trust or donor advised fund.
A few more complex strategies for concentrated stock positions involve limiting the risk of dramatic swings of the price of the stock. These are sophisticated techniques for protecting gains against the risks of high concentration without the full tax consequences of selling the shares.
Here are two short-term hedging/protecting strategies investors could use:
1. A protective put option gives you the right to sell a specified amount of an underlying security at a specified strike price when or before the option expires. That means if your stock is worth $100 per share and you don’t want to risk losing more than 10%, you can buy a put option at $90 and if the stock goes to $90 or below, you can sell your shares for $90.
2. A zero-cost collar. With this, you are protecting your losses by purchasing a put (like above) and selling a call, which is offering buyers the opportunity to purchase the stock at a set price, usually above the current price. The cost of the put is canceled out by what you create in income with selling the call. You forgo some upside potential because by selling the call at a specific price, if the stock goes up in price above that amount, you could be forced to sell the stock below its market value but the put option protects you on the downside.
Aside from the above examples, there are many other long- and short-term strategies available to help protect a concentrated position. The most important thing to realize is that you do have options. If you are worried about the concentration level of certain positions in your portfolio, you should reach out to an advisor to help decide what strategies are best for you and your goals.
Disclosure: Information presented herein is for discussion and illustrative purposes only. The views and opinions expressed by the speakers are as of the date of the recording and are subject to change. These views are not intended as a recommendation to buy or sell any securities, and should not be relied on as financial, tax or legal advice. You should consult with your attorney, finance professional or accountant before implementing any transactions and/or strategies concerning your finances.
