Most investors understand the value of spreading risk across a variety of different securities, sectors, asset classes and geographical regions. Still, any number of unique circumstances could lead an investor to too much exposure in any of the aforementioned areas. One component of wealth management that affects individuals and their families in particular is concentrated holdings of stock in a single company.
A concentrated equity position can potentially represent a substantial portion of an investor’s portfolio. (Think of it as the tallest tree in a forest, waiting for lightning to strike.) Oftentimes, such positions end up in a portfolio through one of the following scenarios: a successful investment (that grew from a low cost basis); an inheritance from a grandparent or parent; ownership in a current or former employer; or business owners who sell their company and receive proceeds in stock. Creating a strategy to manage concentrated equities often involves navigating complex and cumbersome issues.
Think goals, not rules of thumb: While many experts define concentrated risk as a percentage of an investor’s portfolio, the reality is more nuanced. Consider approaching the question of “How much is too much?” through the lens of goals-based planning and investing. Specifically, consider how a significant decline in the equity’s value would impact your goals. Ask yourself, “What is my time horizon? What is my appetite for risk?” “How much can I afford to lose and still be on track to meet my goals and be financially okay?”
If too much exposure to a single company causes you unnecessary stress, this might indicate you need to take some risk off the table. The following four steps can help you get started on weighing your options.
1. Liquidate: When concentrated exposure poses a threat to your overall objectives – or is simply keeping you up at night – your first strategy should be to consider selling off some of your holdings and investing the proceeds in a more diverse mix. Then, there are the usual questions that arise when selling stock, from the tax implications – no small consideration – to current valuations and hypothetical, long-term growth potential. For some, it may make sense to trim holdings incrementally at a set price, whereas others may find selling completely out of the holding in one fell swoop to be the best way forward.
2. Fine-tune the rest of your portfolio: If selling away the holding isn’t an option or doesn’t sufficiently reduce exposure, you can make adjustments elsewhere in your portfolio to minimize risk so that other holdings in your portfolio zig when the concentrated holding zags. This is called a negative correlation.
Keep in mind that diversification isn’t just a matter of holding many different securities or diversifying across sectors or geographical regions – although that all undoubtedly can help. Diversifying is ensuring that your holdings do not move in tandem. Remember to seek out securities and funds that have low correlations to your concentrated holdings. An investment professional can help review your overall portfolio and identify asset classes or securities that have low correlations to your concentrated equity positions.
3. Use hedging judiciously: Equity derivatives have become a popular component of hedging risk in a portfolio. This approach can potentially protect against risk by allowing the investor to specify the amount of risk they are willing to take on – for a premium.
There are a variety of ways to hedge the downside potential of an investor's concentrated holding, while allowing the investor to participate fully in the upside. Keep in mind, however, that the cost of such hedging strategies must be heavily considered, as they can be pricey as well as risky.
4. Consider tax-efficient gifting: If you have philanthropic aspirations, there are a number of ways to leave a meaningful family legacy in a tax-efficient manner.
Charitable Remainder Trusts, for example, allow donors to receive an income tax deduction based on the present value of the charitable contribution. The owner of the trust can then ease out of the concentrated holding and reinvest the proceeds in a more diversified manner – typically in line with the investment policy statement of the charity. The donor always has the option to receive ongoing income from the trust for the remainder of their lifetime and can defer capital gains tax until the distributions are paid out. The distributions to the donor may also result in an income and estate tax deduction. When the donor passes away, the remaining assets go to the charity or charities designated in the Charitable Remainder Trust agreement. Such an arrangement may offer a win-win of diversification and charitable giving.
Seeing the forest for the trees
Understanding an investor’s unique financial needs and the significance a concentrated holding has, either monetarily or emotionally, is crucial to determining which path to follow. The decision to hold, sell or donate your equity should ultimately be driven by your overall financial aspirations, where you are in your financial life cycle and your tolerance for risk.