While concentrated stocks might be a good way to get wealthy, it is not ideal for ‘staying wealthy’ because they lack diversification and liquidity. Furthermore, concentrated stocks could pose tax issues too. As a highly concentrated stock position involves high-risk exposure to the investor, it is often recommended that they diversify the stock position to mitigate the risk.
- What is a Concentrated Stock Position?
- How Does One End Up with a Concentrated Stock Position?
- Why is Concentrated Stock a Risk?
- Diversification Strategies
What is a Concentrated Stock Position?
There is no hard and fast definition of a concentrated stock position. Some describe it as any position greater than 10% or 20% of a portfolio. Perhaps a more logical way to define it would be as the size of an individual position that can negatively affect a financial plan. Depending on the investor’s goals, it could be a position that is just 5% of a portfolio or 50%, as the case may be.
How Does One End Up with a Concentrated Stock Position?
Before we discuss the ways to diversify the stock position, it is important to understand how this situation is created. The most common ways of accumulating concentration of stock is by holding large stock holdings in a single company, usually through employee compensations via stock or stock options. Some might have accumulated large holdings as an initial investment during an initial public offering (IPO) or through the inheritance of a large holding.
Regardless of the ways it was accumulated, diversifying a concentrated stock position is a challenge especially when selling the entire position is not tax-efficient due to significant accrued capital gains.
Why is Concentrated Stock a Risk?
The famous adage, ‘don’t put all your eggs in a single basket', stands true for investment too. Even if you have amassed a large amount of wealth, you could end up with losses if that wealth is concentrated in just one stock. If the company goes bankrupt or loses its stock value, you will end up with nothing.
Another risk of maintaining a concentrated stock is that the company may underperform over a long period. It could be triggered by anything such as the entire sector falling out of favour, changes in regulation, or even mismanagement of the company. In such a scenario, your stock holding becomes a great liability and not a potential value-generating asset that you thought it to be.
Owning a single stock exposes you to higher volatility. It will be risky if you need to liquidate the stock to raise funds. A higher volatility also means that the chance of your stock selling at a lower value is greater than the chance of it selling for a high value.
As it is clear that concentrated stocks bear higher investment risk, the ideal solution is to diversify. There are several strategies to minimise the risk to your investment and net worth. However, you should be mindful of the fact that the strategies discussed here might not be suitable for all investors. The financial instruments mentioned would require the services of an accredited investor under the Securities and Exchange Commission (SEC) Reg D. It means that these tools are useful for high net-worth investors with a significant chunk of concentrated stock that they wish to hedge.
With that in mind, let’s look at the different strategies available for the diversification of concentrated stocks.
Equity collars method is one of the most common hedging strategies and is hence known to most investors. In this method, you purchase a long-dated put option on the concentrated stock holding along with the sale of a long-dated call option. The collar would provide for potential gains and losses, and hence it is not interpreted as a constructive sale by the tax authorities.
While using the equity collar method, the put option gives the holder the right to sell the non-diversified stock position at a given price in the future, along with downside protection. By selling the call option, the investor gets a premium income that can be used to purchase the put option. However, most people usually opt for a costless collar that offers a premium just enough to cover the entire purchase cost of the put option. It means that there is zero net cash outflow requirement from the investor.
Conversely, if you are looking for additional income, you can choose to sell a call option with a higher premium that would result in a net cash flow. But remember that in such a case, the equity collar would limit the value of the stock position between the upper and lower limit over the period of the collar.
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Variable Prepaid Forward
Another popular strategy to diversify consolidated stocks is using a variable prepaid forward contract (VPF). In this case, the investor holding the concentrated stock position agrees to sell the shares at a future date in return for a cash advance at present.
Dependent on the stock’s performance in the market, the number of shares sold at the future date would change in a range. If the stock prices are high, fewer shares would be sold to satisfy the obligation, and vice versa if the stock prices are lower. This variability is one of the reasons for VPF not being regarded as a constructive sale by the tax authorities.
VPF offers immediate liquidity as you would receive cash in advance. Furthermore, VPF also facilitates the deferring of capital gains and flexibility in the choice of the stock’s future sale date.
Pool Shares into an Exchange Fund
The two strategies described above were hedging strategies using over-the-counter derivatives that minimised the downside risk. The next set of strategies not only tries to minimise the downside risk but also provides more room to profit from the upside.
Exchange fund method benefits from the fact that there are a large number of investors in a similar position looking to diversify concentrated stocks. So, in the exchange fund method, several such investors pool their shares into a collaboration where each investor receives a pro-rata share of the fund. It means that the investor now has a share of the fund with a portfolio of various stocks that allows some degree of diversification.
The benefit of this approach is that it offers a measure of diversification while allowing for tax deferrals. However, you should remember that exchange funds typically have a seven-year lock-in period to meet the tax deferral requirements. This caveat could pose a challenge for investors.
Stabilise with a Completion Fund
This is a relatively straightforward strategy that can be easily used to diversify a concentrated stock position. In this method, a completion fund is used to diversify a single position through selling small portions of the holding gradually over time. The money received is then reinvested to purchase a more diversified portfolio. Unlike the exchange fund, in the case of a completion fund, the investor remains in control of the assets. This facilitates diversification within a specific period.
This is a great way to diversify if you are sitting with a concentrated stock of large value. Your stock position would have appreciated significantly over the years, and if you sell it in one transaction, you’ll have to pay taxes immediately. However, if you sell a portion of the stock value, say 10 or 15 percent, then you can easily use the proceeds from the sales to buy newer, diverse stocks without attracting tax liabilities. When you repeat the exercise for a specific period, you’ll end up with a fully diversified portfolio that aligns with your risk tolerance.
Apart from these strategies, you could use some of the methods mentioned below to diversify concentrated stocks.
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Stock Protection Plans
This is essentially more of an insurance type strategy. In a typical SPP, investors holding stock from various industries pool together cash equivalent to 10% of their stock values for the securities they wish to protect. They pay a 2% upfront fee and a 2% annual fee for a five-year holding period, with the most investment made in 5-year Treasury Notes. At the end of five years, in case the stock value has gone down, the fund compensates the stockholder. However, if a recession hits in between, then most of the stocks will go down in value. In such a scenario, there won’t be enough assets in the fund to compensate all investors, and as such it doesn’t offer full protection or safeguard to the owners.
If the time frame is acceptable, the stockholder can consider this option. As the stock is not pledged or exchanged, the stockholder enjoys the right to the stocks, dividends, and voting. But the high fee could be a huge put-off, especially during a market downturn. Also, if the stock value goes up, you might end up with even bigger diversification issues. So, it would be better to exercise caution before choosing this method as a diversification strategy.
Gifting Stock to Charity
If you are looking to reduce stock holdings with capital gains, you can choose to gift the stock directly to non-profit charities. When you donate the stock instead of cash, you reduce your stock position and are likely to get a tax deduction. Donors are eligible for an income tax deduction of up to 30% of adjusted gross income. It is a win-win situation as you can reduce your position and capital gain exposure, while the charity earns money by selling the stock tax-free.
Gifting Stock to Family Members
This is a good way to divest some stocks. It works especially well if you gift stocks to children who are now adults. You can gift them stocks to help with a down payment for a house, buying a car, or funding studies. As the children are likely to be in a lower tax bracket, the capital gains taxes may be lower or nil even if they earn money by selling the stocks.
Most of the strategies described here are useful for stock diversification. However, they are best carried out by a professional financial advisor. But it is always beneficial to know your options and make an informed decision rather than following instructions blindly.
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