Whether you’ve received shares of stock from your company, inherited shares, or simply invested and grown your wealth in a few stock positions over time, you may have a high percentage of your investment portfolio tied up in one or a few companies. This is known as holding a concentrated stock position.
Your investments in this concentrated stock position may have done very well over time, which means you’ve grown substantial amounts of your wealth thanks to these few companies. But what now? How do you ensure that you can preserve the wealth you have created?
Let’s look at two imaginary sisters, Rose and Sofia, who are twins. They both joined their family business, ABC Enterprises, at the same time. Founded by their grandparents, ABC Enterprises has grown over the years to become a publicly traded company.
Rose and Sofia are very talented and were promoted in quick succession to become valued executives. As such, they received executive compensation through options and restricted stock units (RSUs). Over time, they accumulated a substantial amount of wealth thanks to ABC Enterprises’ success.
Now, Rose and Sofia are 50 years old. They each have a portfolio worth $5 million, all of which is tied up in ABC Enterprises’ stock that’s currently valued at $100/share. As they are looking towards retirement, they decide to visit a financial advisor named Tammy to get some guidance.
Tammy notices the concentration in their portfolios and asks them about it. Ever the optimist, Rose responds, “ABC Enterprises is the market leader in our space! I know what’s in our pipeline, and I know we’ll be wowing our customers for years to come! Our share price is just going to continue to climb!”
Sofia counters, “Rose, I love you, but you’ve always worn rose-colored glasses. You know as well as I do that nothing is guaranteed. What if our suppliers face problems? Or trade gets stuck with new regulations? Or tastes change and our consumers no longer enjoy our products? Not everything is within our control.”
Rose replies, “We’ll adapt as we always do! This company has been good to us, Sofia. Look how much it’s given our family. Our family finances are beyond what we’d ever imagined. It would be disloyal to sell our stock. Plus, think about how much we’d be leaving on the table if the share price keeps growing as it’s done in the past!”
“Perhaps I can provide some perspective,” offers Tammy. “Most executives believe in the great work their companies are doing; that’s why they work at those companies. It’s tempting to think the share price will stay on the growth trajectory it’s had. But history is riddled with examples of companies who fell from grace. Remember AT&T? General Electric? Take a look at this chart of the largest 10 companies by market cap (share price multiplied by the number of shares outstanding) in each decade:
Tammy continued, “As you’ll see, few maintain their place of prominence over the long-term. Building wealth through a single stock has been a wonderful gift for you. But now, you might want to consider how to preserve that wealth.”
Over several meetings, they talked more about Rose’s and Sofia’s needs and goals, including their plans for retirement and for their children’s future. Sofia eventually decided to diversify her portfolio, selling her shares in ABC Enterprises and paying the associated taxes to invest in a diversified portfolio of other stocks and bonds. Rose, however, decided to keep her concentrated position.
Over the next 5 years, Sofia’s diversified portfolio (after paying taxes upon the sale of ABC Enterprises shares) grew at about 6% per year, leaving her with a $5.4MM portfolio. Meanwhile, ABC Enterprises continued to grow dramatically. Rose’s $5MM doubled again, leaving her with $10MM. She was elated. But stormy weather was ahead.
Tammy again cautioned Rose. “It’s important to consider your future. $10MM is a lot of eggs to have in one basket.” But Rose insisted, “I don’t want to diversify now! Look how well it’s doing. The price was at $250/share just last month, and now it’s dropped to $200. I just want to wait until it hits $225 again, and then I’ll sell.”
But the price never returned to its prior levels. In fact, a series of regulatory changes meant the company had to retool its production lines. A new entrant gained market share, and ABC Enterprises was suddenly locked in a more competitive landscape. The price dropped to $160. Still, Rose was reluctant to sell. “It’s harder and harder to take those losses. I need to regain at least some of what I’ve lost. Our next product will be even better and will improve the share price.”
Finally, the share price settled around $50/share. Rose’s investment portfolio had plummeted to $2.5MM, half of what she had originally. Thanks to her diversified portfolio, Sofia retired early, traveled the world, and devoted herself to supporting her favorite philanthropic causes. She paid for her children’s graduate schooling and set aside funds for her future grandchildren’s education. But Rose needed to continue to work. She eventually retired comfortably, but her lifestyle was very different than it would have been had she taken some risk and money off the table earlier.
It’s never easy to diversify a concentrated position. Whether you wear rose-colored glasses, convinced of the future increases in share prices, feel sentimental attachment to shares, or are just averse to paying the taxes, it can be emotionally difficult to sell those stocks.
But every moment you wait to diversify means you are potentially taking on undue risk. It’s important to consider what the level of wealth you’ve accumulated will do for you. How much do you really need to accomplish your future goals?
This is where financial planning can help. A good financial plan can show you the tradeoffs for various decisions as well as your “number” – the amount of assets you need to have saved in order to accomplish your goals.
It’s also important to consider the techniques you’ll use to diversify your concentrated positions. The tax impact is a significant consideration, and your financial and tax advisors can help you create the optimal solution to reduce your risk while mitigating taxes.
There are many ways to diversify your concentrated position. Some of the most common include:
There are other investment strategies that can help you diversify or mitigate the risk of your concentrated position. Each comes with its own tradeoffs in terms of fees, liquidity constraints, and tax implications.
For a variety of reasons, some investors may still wish to allocate a portion of their assets to concentrated stock positions. This may be because they wish to take on the risk in favor of the potential upside. It may also be because they are close to the passing of one spouse, which may lead to a step up in cost basis, reducing the embedded capital gains. As long as you are aware of and comfortable with the potential downside risks of holding the concentrated positions, these strategies can also be valid.
At Dowling & Yahnke Wealth Advisors, we regularly help clients navigate the emotional and financial complexities of concentrated stock positions. Whether you are like Rose or like Sofia, please contact us if you’d like to discuss your specific situation.