We occasionally have clients who come to us with concentrated stock positions. They may hold stocks that they invested in early, inherited or earned through stock options, among other reasons.
At Laurel Wealth Planning, we consider a concentrated stock one that accounts for more than 2.5% of a portfolio. Some planners and investors set a higher threshold for what they consider concentrated.
We generally don’t recommend investing large dollar amounts in individual stocks because that can create unnecessary risk. You are making a bet on that one company. If it goes under, you lose your investment. Instead, we generally recommend diversified mutual funds and exchange-traded funds, which can offer broad diversification.
Of course, the flip side is true as well. Concentrating your stock in one company can give you the opportunity to “shoot the moon,” i.e., do extremely well if that company does. But it is hard to know with certainty if a specific company will outperform the stock market in general or a diversified portfolio of stocks. And diversified portfolios of stocks can offer an attractive return: for example, the S&P 500’s average annual return since 1957 is 8%. To get a sense of the potential value of this, if a hypothetical portfolio earned 8% every year, it would double approximately every 9 years.
I often think about my grandma saying she invested in energy companies because people would always need energy. But look at what happened to General Electric. This formerly blue chip stock lost 79% of its value from July 11, 2016, to Dec 3, 2018, As of Nov 10, 2021, it is still far from full recovery.
So, if you already have a portfolio that includes individual stocks, how do you deal with that? Here’s a peek into our process.
We start by assessing what individual stocks a client holds and what percentage of their portfolio they account for. We monitor all client stocks, keeping closer watch of those over 1% of a portfolio and recommending action for those over 2.5%.
Monitoring is helpful, but taking action can be even more helpful. There are many strategies available for dealing with large stock positions and we offer recommendations that we feel fit that particular investors goals and situation. Many investors choose to implement the recommended actions over time because there can be big tax implications. Selling stocks from a taxable, non-retirement account may cost about 15% to 30%+ in capital gains taxes between Federal and State (on the value increase from purchase to sale).
We run this assessment regularly as we “chip away at the gains” and re-evaluate recommended actions. The amount of concentrated stock you may choose to sell will change along with changes in tax laws, your income level and deductions, and the amount of gains and tax.
In the case of inherited stock, sometimes we will need to determine the basis of a stock. This means determining whether you carry the tax liability of the entire gain on the stock or just the amount that has accrued since you inherited it. A step-up basis can reduce the capital gains tax burden when selling that stock.
Our recommended actions will vary depending on the client’s overall financial situation and on the stocks themselves.
For example, someone who largely funds their day-to-day living expenses through pensions and Social Security payments might be able to carry more risk than someone who relies heavily on portfolio draws. A person further from retirement might be willing to carry more risk than someone already in retirement.
The main actions we recommend for stock positions are reduce concentration, trim and use for charitable giving. Here’s a look at each option.
- Reduce concentration: If the stock holding is over 2.5% of a portfolio, we examine whether it’s feasible to sell enough to bring the weighting to under 2.5% of a portfolio.
- Trim: If the stock holding is 1% to 2.5% of a portfolio, it would not be considered concentrated, but we don’t want it to become concentrated. An appropriate next step might be to trim away at it over time, especially if it has a large embedded gain. We also call this “staggering in the gains.”
- Use for charitable giving: You can use your mostly highly appreciated securities (stocks that have gained a lot of value while you have held them) for charitable giving. A common tool to sell a block of stock with no long-term capital gains tax is a donor advised fund. When you move a stock into this fund and then sell it, the gains are not taxed because they will be given to a charitable organization, and you also receive a charitable giving tax deduction. You can contribute to the fund as frequently as you like and then recommend grants to your favorite charitable organizations whenever it makes sense for you. You can reinvest the gains in this account, too, if you plan to make your charitable grants over time. Similar tools are charitable remainder trusts, pooled income funds and gift annuities. Each of these strategies must be evaluated for fit with your goals and tax situation.
As mentioned above, investors often don’t want to sell off an entire stock at once because this likely creates significant capital gains taxes. As we stagger sales and implement the recommended actions, we can employ a few other protective strategies:
- Implement stop losses: When the investor prefers not to sell a stock right away, we might recommend a stop loss order. This puts a “floor” under the stock and automatically sells it if the price hits a certain price. There is no cost to implement a stop loss, but the risk is that a stock recovers after falling and being sold at your target price, making you wish you had never sold.
- Implement a put option: A put is like a stop loss that is not automatic. It gives you the option — but not the obligation — to sell a stock at a predetermined price within a specified window of time. There is a cost to implement a put, and it depends on the selling price (called the strike price) you choose. Think of this as analogous to the cost of purchasing insurance to “put a floor” under the stock.
- Implement a collar: A collar strategy combines the put option described above with a call option. Selling a call option obligates you to sell your shares to the owner of the call if the stock achieves a certain price within a pre-determined time range. A collar can be thought of as buying insurance on a stock and financing the insurance premium by selling away the upside of the stock above a certain price. There are several risks to a collar strategy, and they can be challenging to establish, but it is an option worth exploring.
- Invest in an exchange fund: If you qualify, you can combine your stock with that of others to create a diversified portfolio across the group — made up of each investor’s individual stock positions. This allows shareholders to exchange their concentrated holding for a share in the pool’s more diversified portfolio.
A large stock position has the potential to shoot the moon or take a bad tumble — or anything in between. We recommend managing these positions carefully, in consultation with a financial planner who can look at how these stocks figure into the big picture of your financial life, and with the consultation of a CPA on tax strategies.
Mallory is a Wealth Manager and Shareholder. She listens deeply and helps simplify complex financial situations to help clients move into an easier, clearer future. She aims to give financial advice that is compassionate, wise, and easy to understand.