Concentrated stock is when you have a large portion of your investment portfolio in a single stock. Company founders, board members, senior management, and ESOP participants may receive stock in the company as a benefit of employment. Even some investors can amass shares over time or inherit a large position in a single stock.
These large holdings can create unwanted risk to your portfolio. Even if this stock is doing great in the market, you may need to consider diversifying.
Let's take a look at how a wealth in concentrated stock could sway with the following scenario.
At the beginning of the year, you reviewed your net worth and your financial goals with your advisor. Your family wealth is $6.5 million, with $3.5 million invested in a single stock that you received from being a tech entrepreneur. That single stock has made you wealthy beyond imagination.
Your single stock has ripped higher than the market for the past 10 years and you feel great.
Yet, your financial advisor says you should reduce the risk of having more than 50% of your wealth in a single stock. Why is that?
In this scenario, you may be planning to retire in a year, potentially in 5. And, your investments currently support your retirement lifestyle goals of traveling significantly during your go-go years and continue to grow your art and wine collection.
Your advisor reminds you of Enron. Enron shares gained 27% a year in the 1990’s, outpacing the broader market 14% a year. However, while Enron stock may have made everyone rich, it also wiped out with a 100% loss from January 2001 to January 2002 ($90 a share to zip). More recently, General Electric has fallen from $30 in December 2016 to $10 in May 2019. This is a 67% loss within 30 months.
A good financial advisor will ask you if you could stomach the risk. Could you stomach a 67% decline on your $3.5 million single stock position? It would be worth $1.2 million after that decline, so of course not. You would go crazy. And, that 67% decline might put a crimp in your overseas travel plans.
So what should you do?
Consider the following three options and discuss the pros and cons of each with your trusted financial advisor.
Strategy #1: Create a multi-year plan and commit to selling shares of your concentrated stock.
I know it’s painful to pay capital gains tax of 20%. But consider the benefits of having ‘sleep at night’ protection with investment grade bonds to diversify the overwhelming stock market risk on your balance sheet.
Strategy #2: Get a costless collar.
Is that for your new dog? No, it is an option strategy that allows you to limit losses on the stock you are in love with to no more than 13% down while participating in appreciation up to 9%. This ‘collars’ your single stock value from -13% to + 9% (results vary by individual stock and market conditions). If the CFO of your beloved company turns out to be running an off balance sheet ponzi scheme, you will thank your advisor. Oh, and by the way, 9% up isn’t too shabby.
Strategy #3: Exchange the return of your single stock for the Russel 1000 or the S&P 500.
You can do this with a liquid or an illiquid exchange fund.
The illiquid approach:
You contribute a single stock and get back 30-35 stocks in return seven years later. You should gain large stock market appreciation minus about 1% in fees. The problem with the illiquid approach is foregoing your dividend and you don’t know what stocks you will get back in seven years.
The liquid approach:
Your advisor employs a costless collar to protect your single stock. Then he wraps options that participate in the upside of the S&P 500 as well as downside in that index around the collar. There are some costs to this strategy, but you receive immediate protection for your concentrated position and diversification to the broader large cap stock market in the event of a major market rally or a market decline. The strategy is liquid, meaning you can exit the strategy or sell your single stock at any time. In other words, you maintain control. Plus, with the liquid exchange fund strategy you keep your dividend.
Final thought.
If you don’t want exposure to a broad market decline, particularly in the 10 years leading up to retirement, consider that multi-year plan to sell your concentrated stock position and buy investment grade bonds.
If a single stock made you wealthy enough to meet your lifestyle spending, the Peak Wealth Planning team can help you preserve your wealth by limiting or diversifying equity risk.
- - - - - - - - - - - - - - -
About the Author
Peter Newman is a Chartered Financial Advisor (CFA) and president of Peak Wealth Planning. He works with individuals nationwide that have accumulated wealth through company stock, ESOP shares, real estate, or running a business. Peter applies his unique background to help clients achieve their specific goals and enjoy peace of mind.
Peak Wealth Planning provides concierge services to meet your wealth management needs. Services include: financial planning, investment management, esop diversification, retirement income, insurance, and estate planning advice. Peak Wealth Planning is a fee-based financial advisor based in Champaign, Illinois, and Fraser, Colorado.