It’s not unusual for affluent investors to have concentrated stock positions, which can develop from a number of sources including an inheritance, equity compensation structure, sale of a business, or a high-profile IPO. During periods of low volatility and bullish conditions, a concentrated stock position may not seem like a problem.

But we all know that markets are bound to hit turbulence and when volatility happens and corrections occur, a concentrated stock position may quickly become a vulnerability.

What is a Concentrated Positions

A concentrated stock position occurs when a large amount of your investment portfolio – typically over 10% – is invested in a single stock or small number of stocks. While a concentrated stock strategy may offer significant returns if the stock outperforms the market, it also carries heightened risk due to the potential for substantial losses because of the concentration in a single company.

Risks of Concentrated Stock Positions

A concentrated stock strategy may not weather market volatility as well as a diversified portfolio. Even when looking at relatively small dips and recoveries in a portfolio, history has shown that volatility can put drag on compounded growth. Thus, the risks of concentrated stock positions can be much higher and may reduce an investor’s overall returns when compared to a more diversified portfolio.

Additionally, a concentrated stock strategy may leave investors vulnerable to abrupt losses. Equities can be unpredictable, and companies may have problems under the surface. Even large, established companies can experience existential significant shocks that may lower their stock price.

Why Investors Tend to Hold onto Concentrated Stock Positions

Despite the risk, investors with concentrated stock positions often tend to hold onto those stocks for a variety of reasons:

• They believe the stock will continue to outperform the market indefinitely.
• They want to defer capital gains taxes, especially if the cost basis is low.
• They have an emotional tie to the security because of its personal significance or family history.

They may have difficulty selling a concentrated position if it consists of restricted, unregistered, or controlled securities.

Managing Concentrated Stock Positions 

While the concentration of one’s wealth in a single holding or small group of holdings could potentially provide outsized rewards in the right market conditions, holding concentrated stock positions also comes with substantial risk that may be mitigated with portfolio diversification. When looking to further diversify one’s portfolio, there are multiple ways and solutions that may help clients make that transition away from a concentrated stock position. Here are our views on different courses of action that an investor might take:

• Outright liquidation: This applies only to unrestricted shares and is not always the best answer, though investors can direct proceeds into other investment opportunities for greater diversification.
• Staggered : Gradually winnowing down a concentrated stock position can spread out any capital-gains tax liability over time.
• Charitable giving: Investors, especially those with an emotional tie to their concentrated stock position, may prefer to use it to make charitable gifts during their lifetime. Several techniques are available that can minimize taxes, including a charitable remainder trust, which has the potential to produce a potential income stream for a specified term.
• Option collars: Option collars allow clients to generally keep their stock and from selling by incorporating strategies that create downside protection while limiting unrealized gains on the upside.
• Call option transition plan: Some investors may want to use the sale of call options on a concentrated stock to provide them with defined dates/outcomes as to when the stock will be sold while also providing the opportunity to collect income on their concentrated position.
• Direct indexing: Direct indexing involves taking proceeds from the sale of a concentrated stock, which will then be invested in an index and tax loss harvested to offset the gains.
• Hedged Equity Exchange: A hedged equity exchange refers to maintaining a concentrated stock position but transferring one’s risk from a single stock (idiosyncratic risk) to a broad index (market risk).

From our perspective, the benefit to these various solutions is that they are all highly customizable and can be tailored to meet the income needs, risk tolerance, and tax situations of each individual client.

For additional information about managing concentrated stock positions, read our detailed white paper, and consult with a Kayne Anderson Rudnick Wealth Advisor today.