By Jeff Deiss
From an investment perspective, concentration in a single stock is associated with the potential for massive gains. A large stock position acquired through years of executive compensation, superior price appreciation or an inheritance can produce significant family wealth. At the same time, that wealth may become dangerously concentrated, presenting considerable risks.
The reasons for holding onto concentrated stock positions include insider selling constraints, indecision over the current price or assuming that the future will look like the past, having an emotional attachment to the stock or concern over the tax implications of selling.
Taking any action on a concentrated stock position starts with how it fits into your overall financial situation and long term goals. For example, Microsoft employee whose net worth is $2 million of which $1 million is company stock and options is in a much different position than an Amazon employee worth $50 million and who only owns $10 million in company stock.
If you expect to rely on the wealth gained through a concentrated position, or part of it, in your lifetime for retirement income or to purchase a property or pay for educational expenses, then you have to come to terms that taxes will need to be paid and you’ll have 70% to 85% or so of what you’ve gained to spend on these goals depending on what state you live in.
In the above example, the Amazon employee likely has more ability to live the life they want regardless of what happens to the Amazon stock and so the risk of holding onto it is lower.
From there, you can get a bit more specific in terms of your status, are you an insider or control person at your company? What’s your outlook for the stock itself and the markets? What’s your tax bracket and what do the tax implications look like for you?
It’s part math and it’s part emotion and there is no one size fits all in my experience. The key is not to let your emotions or the potential tax hit derail you from reaching your long term goals.
It’s easy to get caught up in a winning stock. Holding a winner feels good. It reminds us of our investment skill…or luck. If you find yourself in this situation, the first thing you need to remind yourself is that past performance is not a guarantee of future results. If a company has run up in value, then this is great of course, but you really need to take a step back and ask why. Even if a company has done well and has great growth and earnings prospects, the stock or the overall stock market can still become overvalued relative to the market and other stocks like it.
When companies are overvalued, there is typically not a lot of room for error in order to keep meeting the market’s expectations. An earnings miss, an accounting error of a restatement of earnings or headline risk can bring a dramatic change in momentum.
Sometimes I do wonder whether we live in the United States of America or the United State of Amazon. It seems like there is nothing they don’t do. But at some point, something will change with Amazon and also Google and Facebook, etc. No stock has gone up in a straight line forever.
There are plenty of studies that show how top performing stocks for a given time period end up lagging in the future. Of the Top 10 companies on Fortune Magazine’s “Most Admired Companies” back in 2000 (and which included Microsoft, Cisco, Home Depot, Dell, Intel and GE), seven lost at least half of their value during the bear market that followed over the next 2 ½ years. That may or may not be the type of risk you want to take, particularly if the time that you might need the wealth created by a concentrated position coincides with a time where the stock underperforms.
Think of the concept of playing with house money, like when you’re at the casino and playing with the money you’ve won. The majority of the time folks are willing to lose all of what they’ve won and happily walk out with what they brought, or even a little less. And the same concept holds with a stock that has run up in value. It may be better to take some chips off of the table while things are still really good by selling high or monetizing or collaring the stock while things are still good.
Hedging strategies, diversification strategies and monetization strategies using options are available and may be appealing. Some are straightforward and some are complicated – and none solve the issue of paying capital gains taxes. Unless your position is in the tens of millions or hundreds of millions of dollars, then you’re not likely to need them all. In fact, you may not need any.
Understanding these strategies requires an education for most of us and this is where having a good advisor who understands your overall situation adds value as they can parse through what you don’t need so that you’re not needlessly wasting time energy on it.
Market volatility can also make difficult to execute a strategy. You may, at long last, finally get to the point of making decision and then the price of your stock suddenly moves and you change your mind as a result. Your target price is now somewhere else and you find yourself paralyzed all over again.
The same is true for options strategies, where pricing is sensitive to volatility and the result is that options are the most expensive when they are most needed. It’s like shopping for flood insurance after the hurricane.
In many cases, and even if it’s not currently broken, you might actually feel better doing something sooner.
With inherited stock, the first thing to remember is not to confuse what’s familiar with what’s safe. I still know people who own the GE stock they inherited. The second thing to remember with inherited stock is that your goals and needs are probably not the same as those of the person you inherited the assets from. And they may be happier if they see you benefit from what you’ve inherited during their lifetime.
Remember, it’s part math and part emotion. Working with your advisor on a concentrated position helps you to step back and look at your situation objectively and holistically, which can help you take the emotion out of it. It’s not uncommon that investors with big gains actually know what they need to do, but they just can’t bring themselves to do it.
A concentrated position may generate significant wealth, but a diversified portfolio will help you to preserve and keep your wealth. This is where your advisor can help.
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