All Posts

6 Smart Ways to Manage Concentrated Stock

6 Smart Ways To Manage Concentrated Stock
Do more with what you’ve earned.

Financial advisors for successful professionals, executives, and business owners.

So, you have a large position in a single stock. This stock represents 10%, 20%, or even more of your investment portfolio. Maybe you built up this stock position through your employer’s stock compensation plan (RSUs, ESPPs, stock options, etc.). Or maybe you inherited the stock. Perhaps you bought the stock, and it performed extraordinarily well and grew to its current size. 

Whatever the reason, you likely recognize the significant amount of risk this position creates – a large part of your wealth is tied up in a single stock, and it can quickly lose its value

Any number of bad news can quickly derail a stock’s price performance—poor executive leadership, a downgrade of the entire industry, too lofty expectations, or anything else—the possibilities are literally endless. 

The idiosyncratic risk of holding onto a single investment contradicts a core investment tenet—don’t put all of your eggs in one basket.

In this guide, we discuss the number one reason why you should not hold a single stock position and the psychological reasons preventing you from selling. We then outline 6 ways to effectively manage your concentrated stock:

  1. Structured Selling
  2. Charitable Giving
  3. Option Strategies
  4. Exchange Funds
  5. Stock Protection Plans
  6. Sell It All Now

Most Stocks Underperform

Contrary to popular belief, most stocks perform quite poorly. Believe it or not, it is quite rare for a single stock to outperform the benchmark (often the S&P 500). So if you are sitting on a single stock position that has performed extraordinarily well, consider yourself lucky. You hit the jackpot. 

The stock market is not evenly distributed—where 50% of stocks perform better than average and 50% perform worse than average. Instead, the market is positively skewed, with the distribution of returns having a very long right tail. Because it is positively skewed, a relatively small number of excellent performers disproportionately influence the market’s overall return (this is a good thing).

Most Stocks Underperform

In other words, the stocks on the right end of the distribution tail generate such large returns that they more than offset all other stocks that underperform. Only 22% of stocks in the S&P 500 outperformed the mean from 2000 to 2020.

Of course, it is tempting to ‘identify’ the stocks that will become one of those excellent performers and invest only in them. But as we already know, this is a fool’s errand that will eventually lead to poor performance. This is why we invest the way that we do. 

The point of all of this is that if you are sitting on a concentrated stock, chances are very high (~80%) that this stock will underperform the market. This, above all else, is the reason why you should seriously consider getting out of this stock.

Get Out Of Your Own Way

The most common reason an investor has such difficulty selling a concentration position is not due to taxes but rather a psychological barrier. Yes, the taxable consequence of selling such a concentrated position is often a significant barrier. But, in our experience, an investor’s inaction is often rooted in ‘anchoring,’ a psychological phenomenon where an individual bases their decision around an established reference point.

image 9

For example, let’s say that you accumulated significant wealth within a company you’ve worked at for decades. You love the company. You know a lot about its operations, pipeline, and it’s strengths. You think the company has a bright future, even if you no longer work there. You find it difficult to invest in anything else as no other stock (or portfolio of stocks, or investment opportunity you’ve seen) gives you the same level of confidence. So, therefore, you are reticent to sell this position as you fear that by doing so, you will downgrade your portfolio. Sound familiar?

Another example is if you inherited the stock position. Let’s suppose that a stock has been in your family for generations. Your grandparents owned this stock, and it has served them well over time. The same can be said about your parents. So much of your family’s history is tied to this stock. To sell the stock is to disregard all that it has done for your family’s legacy. It has been an excellent performer over time. You find yourself thinking that it would be difficult to find a suitable replacement. 

It is vital to remember that an individual stock is simply an investment. It is a tool to help an individual reach their financial goals. No more, no less. A stock may have performed well in the past, but there is no guarantee that it will continue to perform well in the future. In fact, the odds are stacked against it. 

In 2001, the largest company in the U.S. was General Electric. Today, it barely remains within the S&P 500, and its return since that time is -61%.

Strategy 1: Structured Selling

The most straightforward strategy to manage your concentrated stock position is to sell the position gradually. This approach involves selling the stock over a period of time, typically three to five years. The main advantage of this strategy is that it allows you to spread the tax burden over several years, which can be beneficial if you expect changes in your income that may affect your tax bracket.

structured selling calendar

This can be a sensible choice for investors anticipating a shift in their income or tax situation in the coming years. Additionally, selling over time reduces the risk of selling at an unfavorable price due to short-term market fluctuations.

Remember that with a structured selling strategy, you will still hold onto a large concentrated position for an extended period. This exposes you to the risk of the stock price declining. The stock’s value could plummet before you’ve completed the selling process, leaving you with lower net returns, even when considering the tax liability of selling all at once.

Strategy 2: Charitable Giving

This is an excellent option if you are in a position where you can comfortably meet all of your future spending needs without some or all of this stock’s value. You can either donate the stock directly to a charity of your choice or contribute it to a donor-advised fund, which allows you to take an immediate tax deduction while retaining the ability to gift to multiple charities over time.

501c non profit tax

Donating stock to charity provides an upfront tax deduction, which can be advantageous if you have a high income or face a substantial tax liability. Additionally, by giving to a donor-advised fund, you can diversify your charitable giving over time, spreading your contributions to various causes and organizations.

Once you donate the stock, however, you relinquish control over its future performance. If the stock performs exceptionally well after the donation, you will not benefit from its growth. Moreover, deductions for charitable contributions are subject to IRS rules and limitations, so it’s essential to ensure that you comply with all relevant regulations.

Strategy 3: Option Strategies

Option strategies involve using financial derivatives, options to limit downside risk while potentially capping upside potential. There are two common option strategies for managing concentrated stock: buying puts and selling calls.

puts vs calls
Source: The Balance

Buying Puts

Buying puts provides you with the right to sell your stock at a predetermined price, protecting you from substantial declines in its value. This can be an effective way to hedge against downside risk, as it allows you to lock in a minimum sale price for your stock. 

This strategy can be particularly appealing if you believe that the stock is overvalued or if you anticipate significant market volatility. Note that option trading can be intricate and requires a significant understanding of the financial markets. Additionally, constantly having to buy puts over time, which will likely occur if you implement a strategy like this, will involve transaction costs and premiums, which will reduce your overall return.

Selling Calls

Selling calls gives someone else the right to buy your stock at a predetermined price, providing you with some income and limiting your potential gains. This strategy, also referred to as a covered call strategy, can generate additional income from your concentrated stock position, which can help offset potential losses. You can profit from the stock’s current value while still potentially benefitting from its future growth.

As with anything else in life, there is a cost to consider. When you sell calls, you are obligated to sell your stock at the predetermined price if the buyer exercises their option. This means you risk missing out on additional gains if the stock’s value increases significantly beyond the predetermined strike price.

Strategy 4: Exchange Funds

An exchange fund is a pooled investment vehicle that allows investors to exchange their concentrated stock for shares of a diversified portfolio. This strategy provides immediate diversification without incurring immediate tax consequences.

An exchange fund, also called a swap fund, aggregates the concentrated stock positions of many investors, creating a diversified collection of stock. You swap your concentrated position for a partnership interest or share of the exchange fund itself. By doing this, you avoid an immediate taxable event while diversifying your risk. 

There are drawbacks, of course, to these products. Exchange funds are structured as a private placement limited partnership, meaning only accredited investors with over $5MM in net worth can participate. There are also severe lock-up periods, typically lasting ten years, during which you cannot sell your newly acquired shares. 

Management fees are also quite high, from 1.5% to 2.0% per year. This means that by investing in an exchange fund, its performance will have to clear a 20% hurdle (10 years X 2.0%) just to break even. 

Strategy 5: Stock Protection Plans

A stock protection plan is a relatively new strategy where investors contribute cash into a cash pool, which is used to reimburse losses. If any stock from participants experiences any substantial declines, the pooled cash helps to compensate that affected investor. This differs from an exchange fund as investors only contribute cash to the pool (not stock) and would only receive cash if any losses are realized.

exchange fund vs stock protection fund

Think of a stock protection plan as a form of insurance against large losses within your individual stock. Investors participating in this plan come from different industries, which are often counter-cyclical to each other. When one industry declines due to a particular economic climate, another may outperform. This can minimize any significant losses among multiple participants.

While novel, stock protection plans are expensive and offer no tax advantages. First, you have to contribute 10% of your stock’s value to the cash pool. The cash pool is then invested into U.S. Government bonds for five years. After five years, the cash pool is disbursed to those with stock losses.

If your stock does not decline over the five years (0% total gain or better), then you lose the entire 10% amount contributed. The only scenario where you would have any recourse is if your stock declined in value. Even then, the amount that can be distributed is limited to the cash pool amount. It is entirely possible that an investor with stock losses is not made whole. 

Strategy 6: Sell It All Now

There is something to be said for selling the entire stock position now. Yes, this is probably the least tax-efficient method. Yes, this is probably the most jarring option available. However, if you are mentally ready to sell this position and if you are eager to reduce your portfolio risk, then selling the position might be the best overall strategy. No longer worrying about the stock and achieving peace of mind cannot be understated. More times than not, simple is better. 

Find What Works For You

There is no right way of managing concentrated stock that applies to everyone. Each person’s scenario is unique, and it requires careful consideration of many factors, including tax implications, projected income, risk tolerance, and investment goals. Each of the six strategies has its own advantages and disadvantages. While some strategies offer immediate tax benefits or downside protection, others focus on diversification and long-term planning.

Feel free to reach out to us if you need help navigating your concentrated stock position. We will be more than happy to assist.

Schedule Meeting

The
Wealth
Shift
Journal

Free Subscription

Learn how you can capitalize on the economy’s changing tides with a pragmatic approach to planning and investing. Get a free bi-weekly email with expert insights from Bull Oak’s wealth management team.