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Managing Concentrated Stock Positions

Managing Concentrated Stock Positions

Contents
November 6, 2020

Acknowledging the Risk

It’s not unusual for affluent investors to have concentrated stock positions. 

An inheritance, equity compensation structure, sale of a business, IPO, or a very fortunate stock investment can result in an outsized holding in a single security. In a period of low stock volatility and a one-directional bull market, a concentrated position may not seem like a problem. But, we all know that markets don’t move for long in one direction. Turbulence happens, corrections occur, and that concentrated position can quickly become a vulnerability.

Even when you are looking at relatively small dips and recoveries in your portfolio, history has shown that any volatility can put what’s known as “drag” on compounded growth. 

Although all equity investors face market risk, those with concentrated positions also face risk unique to that single stock. History has also shown that volatility, measured by standard deviations of stock returns, is greater for single stocks than for a diversified stock portfolio. While past performance is no guarantee of future results, this all means that, over time, your concentrated position is likely to reduce your overall returns, compared to a diversified portfolio.

Of course, in addition to that long-term risk, you run the risk of abrupt loss. Equities are unpredictable, and companies may have problems under the surface. Even large, established companies can go into bankruptcy, and even the best-managed companies can experience sudden challenges that drop their stock price.

Why Investors Balk at Letting Go

Despite the risk potential, Investors with concentrated positions often tend to hold onto them. They may:

  • Believe the stock will continue to outperform indefinitely (although rationally, we all know better)
  • Wish to defer capital gains taxes, especially if the cost basis is low
  • Have an emotional tie to the security, for personal or family reasons

There may also be issues with selling a concentrated position if it consists of restricted, unregistered, or control securities.

Potential Solutions to Help Reduce the Risk

There is no one-size-fits-all solution for managing concentrated holdings. Factors such as individual risk tolerance, investment horizon, desired returns, and asset balance in the total portfolio should be considered carefully. Some possible executable actions include:

Outright liquidation. This applies only to unrestricted shares and is not always the best answer. Proceeds can be redirected into other investing opportunities for diversification.

Staged selling. Gradually siphoning down a concentrated position spreads out the capital-gains tax liability over time.

Hedging via derivatives. An equity collar is a combination of put and call options that creates a band around the stock’s price and limits both the downside and upside. It can also be utilized as collateral to monetize the stock without triggering taxes. A prepaid variable forward contract can also be used to lock in profits and defer taxes.

Exchange funds. You aren’t alone. These private-placement limited partnerships allow multiple investors to exchange shares of their concentrated positions in highly appreciated equities for ownership stakes in a resulting diversified fund. Capital-gains taxes are not triggered.

Charitable giving. Investors, especially those with an emotional tie to their concentrated position, may prefer to use it to make charitable gifts during their lifetime. Several techniques are available that can minimize taxes. A charitable remainder trust can even produce a potential income stream for a specified term.

 

For additional information about managing your concentrated stock position, read our detailed White Paper and consult with a Kayne Anderson Rudnick Wealth Management advisor today.

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