4 Ways to Diversify Concentrated Stock Positions (EP.118)

0:21Welcome to The Long-Term Investor. Today, we are going to be talking about managing concentrated stock positions. Whether acquired through employee compensation, inheritance, or a singularly successful investment, these significant holdings in one company can dominate your portfolio. And while they might represent financial successes or maybe even deep-rooted loyalties, concentrated positions introduce unique challenges, and they amplify the highs and lows of market volatility on one's financial well-being. In this episode, we'll dissect the complexities of these positions, explore the inherent risks, and provide guidance on strategically managing and, if necessary, diversifying these holdings.

1:04But first, let's start with why investors own concentrated stock positions in the first place. There are three scenarios we encounter most frequently at PlanCorp. The first are individuals who acquire a concentrated stock position through employee compensation plans, whether that's stock options, restricted stock units, or some other equity-based compensation as part of their benefits package. Now, over time, as these options vest or as the company grows and succeeds, employees may find that a substantial portion of their wealth is tied up in that company stock. Another frequent source of concentrated stock positions is inheritance.

1:43It's common for relatives to avoid selling their most highly appreciated positions with the idea that at their death, the cost basis will step up for their heirs and allow them to sell that position at no gain. Now, there are other instances where the deceased's trust is such that there is no step up in basis, but either way, the inheritor of wealth often finds themselves holding a significant amount of a single stock. The third scenario that I tend to see pop up, particularly with new and prospective clients, is an individual who holds an individual stock that has performed exceptionally well and now makes up a significant portion of their wealth.

2:22So while a concentrated stock position can be the result of good fortune, loyalty, or legacy, it presents its own unique challenges. And the most obvious and often cited is the risk of the lack of diversification, As the old adage goes, you don't want to put all your eggs in one basket. A portfolio dominated by one stock is highly vulnerable to that company's fortune, and a significant downturn in that company or even the sector can result in a large financial loss. Another challenge with having a large portion of wealth tied up in a single stock is that it can create this strong emotional connection to the company, and this emotional bias starts to cloud your judgment and make it difficult to make objective decisions about when to sell or how to manage the position.

3:09Another unique challenge that comes to mind is reduced liquidity. A concentrated position isn't always easy to sell, especially if it's a significant portion of the company's total shares or if the stock's trading volume is low. But really with any position, whenever you're liquidating something that's large enough that can move the market, that can potentially result in a lower selling price. And speaking of things that can lower your wealth, tax implications has to be one of the largest challenges for people with a concentrated stock position. Selling a large position, especially one that has appreciated significantly, can obviously have significant capital gain tax implications.

3:48Now, this consideration can deter investors from diversifying that position, even when it might be in their best interest. So these tax implications, they create both a financial and a behavioral challenge for investors to overcome. Lastly, I want to really emphasize what I feel like is the most overlooked challenge posed by a concentrated stock position, and that's simply opportunity cost. By remaining heavily invested in one stock, investors potentially miss out on gains from other companies or sectors. Now, I dedicate an entire episode to this topic if you want to scroll back in your podcast app to episode 63, which is titled, Should You Invest in Individual Stocks?

4:28And you can also find that episode and the related blog post by visiting thelongterminvestor.com. But here's the short of it. Only about 4 % of stocks make up the total U.S. stock market return. And two-thirds of all stocks underperform the total U.S. stock market. Two-thirds. So I think sometimes people see large gains on their concentrated position over a certain period of time, but they don't realize that they are probably underperforming the broad stock market. And in instances where they are outperforming the broad stock market, let me share one more statistic with you. Roughly 40 % of all stocks, all stocks, have suffered a permanent decline of at least 70 % from their peak value.

5:11So not only do concentrated stock positions create meaningful opportunity costs, but as I mentioned earlier, they're just incredibly risky in the first place. Now that we've addressed some of the challenges that investors face when they hold a concentrated stock position, let's talk a little bit about some of these strategies for unraveling that position. And to me, strategically managing a concentrated stock position always starts with setting clear objectives. Because if you're relying on this stock for retirement, your strategy is probably going to differ from someone who views it as a bonus or a position that's going to be passed on to future generations.

5:48So with that in mind, there are four ways I'd like to talk about managing concentrated stock positions. The first are separately managed accounts with a tax-loss harvesting emphasis. So if you're worried about the tax implications of selling off parts of your concentrated stock, tax-loss harvesting to offset the capital gains can be an effective way to move towards a more diversified portfolio, all without incurring a big tax bill. Just to level set here, tax-loss harvesting is an investment strategy where underperforming investments are sold to realize losses, which can offset taxable capital gains from other investments.

6:25Later, the sold investments can be replaced with similar ones to maintain the desired portfolio allocation. The problem with relying on mutual funds or ETFs for tax loss harvesting opportunities is that they are typically only at a loss when the market is in a correction or a bear market. Now, as long-term listeners of the show know, market losses are pretty normal. For example, the S &P 500 averages a decline of 10 % or more about every 12 months and a decline of 20 % or more every three to four years. So that type of market decline should be expected by stock market investors of all kinds and honestly just treated as a normal and healthy occurrence regardless for the reason behind the decline.

7:07But if you've been invested in a mutual fund or an ETF for several years, even a bear market often won't drive the position down enough to be harvested at a loss. Enter separately managed accounts, or SMAs, which are like having your very own private mutual fund or ETF. But unlike owning a mutual fund or ETF, you can tax-loss harvest even when the market is up and the overall position isn't at a loss. Let me explain. SMAs enable investors to take advantage of tax-loss harvesting opportunities by selling losing positions within what I'm referring to as your own private mutual fund and buying similar stocks to maintain their exposure to the market.

7:49For example, maybe your SMA manager sells Coca-Cola at a loss and buys Pepsi or sells Johnson & Johnson at a loss and buys Pfizer in its place or sells ExxonMobil and buys Chevron. You get the point. Unlike an ETF or mutual fund, which requires the entire index to be at a loss in order to perform tax-loss harvesting, Investors can harvest losses at the individual security level within an SMA, which can then be used to sell portions of the concentrated stock position that is trading at a gain. And you'd be surprised how many stocks are trading at a loss in years when the overall market is up, which you can clearly see in a chart that I've included at the show notes at thelongterminvestor.com, looking at the Russell 3000 index from 1998 to 2022.

8:37Every single year had stocks with negative of returns, regardless of what the market did. If you'd like to learn more about this strategy, you can refer to episode 95 titled What is Direct Indexing in your podcast app or by visiting thelongterminvestor.com just to go a level or two deeper on this topic. But for now, I'd like to transition to the next strategy, which is contributing concentrated stock to an exchange fund. Exchange funds offer a mechanism to diversify positions without triggering immediate capital gains taxes. I sometimes compare them to a potluck, but for stocks, where various investors can contribute their concentrated stock positions into a pooled fund that seeks to track a broad market index, such as the Russell 3000.

9:21Investors contribute their appreciated shares of a single stock to the exchange fund, and in return, they receive a pro rata share of the fund, which comprises of the diversified portfolio of various stocks contributed by all participants. In essence, they are swapping their single stock position for a share in a broader portfolio. Like all good things, there are trade-offs. And in this case, the trade-off for this immediate diversification without capital gains is a multi-year loss of liquidity, as these funds typically have lock-up periods that prevent you from accessing the capital without penalty.

9:56Although it's worth noting, death is a common exception in which you can get instant liquidity with no early withdrawal penalties. But to me, the lack of liquidity is a very small concession to make in exchange for instant diversification without any immediate tax bill. This next strategy is less about diversification and more about creating a greater certainty of outcomes using option collars. An option collar is akin to putting bumpers on a bowling lane. The bumpers prevent your ball from going into the gutter and ensuring that it stays within certain bounds. Just like an option collar sets a ceiling and a floor for your stock's price, limiting both the potential loss and gain.

10:37In essence, an option collar involves holding the stock, buying a put option, which gives you the right to sell the stock at a predetermined price, and selling a call option where you agree to sell the stock if it reaches a certain higher price. These combinations of actions form a color around the stock's potential price movement. So just to throw a few numbers out as an example, let's say you own a stock currently priced at$100. You might buy a put option with a strike price of$90 and sell a call option with a strike price of$110. This means that if the stock price falls, you can still sell it for$90, which limits your loss.

11:19But if the stock prices rises above$110, the call option buyer can buy it from you at that price, thus limiting your gain. The primary advantage of this strategy is that it provides a safety net against a drop in the stock's price. By purchasing a put option, you know the minimum amount you can sell the stock for, thus capping potential losses. The most significant drawback, in my opinion, is that the gains are limited. If the stock price surges, you won't be able to benefit beyond the call's option strike price, since the call option buyer is likely going to exercise their right to buy the stock from you at that predetermined price.

11:57Similarly, by locking in a range of outcomes for a single stock, rather than diversifying broadly into the market, you're giving up the upside that comes with owning the entire market. Another potential downside are just the tax implications, especially if the options are bought and sold without being exercised. If you go down this path, it is crucial to keep detailed records and possibly consult with a tax professional to ensure compliance and optimization. And if the call option is exercised, just know that you'll be incurring a capital gain perhaps at a time that may not be optimal. I'm giving some disadvantages here, but do remember, option callers can be very effective.

12:37It just really depends on how and when it's used. The last strategy I want to talk about when it comes to managing your concentrated stock position is by far the simplest. And that's just to diversify gradually. Selling at some sort of regular interval, a portion of your stock, and then reinvesting the proceeds in other areas. After all, it usually doesn't make sense to let the tax tail wag the dog. And if you truly believe in the historical research showing that individual stocks dramatically underperform the overall market, then the outcome of selling a stock, paying the capital gains, and reinvesting in the broad market will be determined by how that stock performs relative to the broad market after the sale and how long the owner would have held the stock otherwise, basically until the step up in cost basis at death.

13:27Now, I've included a table in the show notes that does exactly that. And in only a very small number of cases, would the impact of taxation negate the benefits of selling? When you look at this table at the show notes, I think you'll agree with me that for most concentrated stockholders, excluding those at a very advanced age. You shouldn't let taxes drive the diversification discussion or any strategic plan to systematically reduce the exposure to a concentrated position. That's all I have for today. If you found value in this episode, there are a few things you can do to support the growth of the show.

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14:43Again, thank you for listening. And until next time to long-term investing. Thanks for listening to the Long-Term Investor podcast. To access free financial resources and submit questions to be answered on the show, visit thelongterminvestor.com. Peter Lazaroff is an employee of PlanCorp and BrightPlan. All opinions expressed by Peter and any podcast guests are solely their own opinions and do not reflect the opinions of PlanCorp or BrightPlan. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of PlanCorp and BrightPlan may maintain positions in the securities discussed in this podcast.