Warning: A Concentrated Stock Position Can Be Hazardous to Your Wealth

A Concentrated Stock Position Creates Risk That Goes Beyond Market Risk 

Reduce 5 threats to your entire financial house by taking a broader view

Let’s start at the beginning. When you google “concentrated stock”, the top search results are:

• Managing the concentrated stock position
• Diversifying out of the concentrated stock position
• Risks or “costs” of holding concentrated stock position
• Or possibly some marketing material getting you to choose another investment instead

At Spark Financial Advisors, we have a sliding scale view of concentrated stock positions. This is because there isn’t one hard and fast way to define a concentrated position. It also isn’t just about the value relative to your portfolio. There is a broader context people need to consider.

A concentrated stock position means holding a large amount of one stock (one company) which overly exposes your portfolio to the success or failure of that one company. It is the opposite of diversification. 

We collectively agree that >5% of a portfolio value starts to creep into the concentrated stock category. That’s when we want to have a conversation about the merits of the company, the backstory of how the position accumulated, and then the risks associated with it. It doesn’t necessarily mean a full sell (or keep) recommendation…yet.

If the position is > 7% but less than 10%, our main concern is if your overall financial plan is on track or if this is subjecting your resources to too much additional risk. If so, we want to create a plan to divest from the holding in a tax-efficient manner. This is especially critical for those approaching retirement — our retirement planning team builds plans that account for concentration risk alongside all other retirement income variables.

If the position is > 10%, a red flag is raised and we may need to take prompt action!

If the stock is on a tear of positive performance, this creates exuberance and you may feel like you want to own more but this story could get a lot worse before it gets better. Read here for a real life example of a near-retiree working for a big bank before the housing crisis in 2008.

Read: What To Do With A Concentrated Stock Position

The above article is fantastic at covering the basics of managing a concentrated stock positions. (After all, it is a Spark article. #humblebrag) Most importantly it details the ways we HOPE  you untangle the concentrated stock position. (You have to read the bottom half of the article to know what that means.)

Concentrated stock positions often come with a tricky origin story around how you accumulated the position in the first place

Common backstories we see are:

• Holding company stock (because of stock options, company matches in stock, loyalty to a company, etc.).
• You inherited stock and keeping the shares is sentimental or the tax burden of selling seems too hard and too big.
• You have an emotional attachment to a stock because it has done so well for you!

But let’s take it a step further.

Contextually to life, why does a concentrated stock position matter?

Investing in the market is good, isn’t it? 

Concentrated stock positions can be dangerous beyond the risk of market fluctuations. 

1. Tied to your human capital

Your human capital “consists of the knowledge, skills, and health that people invest in and accumulate throughout their lives, enabling them to realize their potential as productive members of society.” (World Bank definition). Your human capital is typically your profession and if your human capital is tied to the same company as your stock (because it is company stock), then you are double exposed!

For example, if your career is centered around a technology company and you invest in that company stock, what could happen when that specific technology falters in particular market conditions?  Think slow economic growth, mergers & acquisitions, and company layoffs. Yikes! Then all of a sudden your financial future is no longer as secure. Not only could your company stock’s value go down but your human capital is tied to this category and you could lose your job. This is a double whammy.

2. One industry is overrepresented

This is similar to the above except that the risk specifically focuses on one industry being too prevalent in your portfolio. Diversification is not only across the globe and size of company, but also types of companies. 

Some sector or industry examples:

• Financial 
• Healthcare
• IT
• Energy
• Utilities
• Industrial 
• And more

If you have a diversified portfolio and then a concentrated position of one specific stock, you could be overly exposed to one of these sectors. This creates additional risk to you as an investor since certain sectors perform better in certain market environments. The problem is we never know exactly what the future holds, so we always want all the sectors represented in a balanced way that doesn’t overly expose your hard earned dollars to one industry.

The Dimensional Fund Advisors chart below illustrates this point from 2014 through 2023. Pick Information Technology. Information Technology was the highest performer for 2023 but almost at the bottom for 2022 and back in the middle in 2021. It hops around. Each category does this. No one sector was a consistent outperformer.

The market offers investing in a multitude of companies, industries, countries and we never know which one will come out on top for the year. Without an obvious pattern, diversification and data drive us to hold all sectors and avoid concentrated positions.

3. Contributes to portfolio drift and can mess up your whole portfolio strategy

When you hold any investment, that investment is going to have relative performance. If you are not initiating or participating in systematic, disciplined rebalancing, then this category of investing is going to drift from its target asset allocation.

That is when rebalancing is appropriate. Read: Charles Schwab Rebalancing in Action

At Spark we review our clients portfolio allocation multiple times a year. A rebalance may be necessary when the client’s asset allocation goes outside of our tolerance bands, when cash is added or subtracted from the portfolio, and/or when a major life event or allocation change occurs. If you own a lot of one company’s stock without a plan to review your portfolio and monitor how this company’s stock performance influences your own portfolio’s allocation, then you are just drifting in the water without purposeful direction. Wandering can be fun in a charming town but it is dangerous to float in the open ocean of investing.

Rebalancing is a simple concept but in practice, there are many layers (Read: Morningstar’s the why and how of rebalancing). Want a professional’s help? Contact us.

4. Tax Consequences in taxable portfolio

Sometimes an investor may hold on to a concentrated position for a variety of reasons but we often see the common thread is holding on to the position for too long in an attempt to avoid taxes. Long-term capital gains rules will apply for holdings over 12 months and provide for a reduced tax consequence compared to short-term gains. However there may still be a very large gain to absorb for your tax picture that year. Read IRS website for more information.

Here are some strategies and reasons the tax might be worth taking!

• If you think paying capital gains is painful, watching a huge chunk of your portfolio tank is much worse
• If you expect your income to be lower this year and/or tax rates to go up in the future.
• You could spread out the taxable gain over multiple years (perhaps proactively selecting lower income years) to have a disciplined strategy to reduce the concentrated stock position to less than a 5-7% exposure.
• If you choose to take the gains sooner rather than later, then you position yourself to have less stress going forward. Gain confidence with a diversified portfolio that treats investing as data driven vs. speculation and gambling risks.
• Statistically most stocks underperform the broader market, what are the chances your holding beats the odds?

5. Emotional bias present

We also see emotional biases present when investors hold concentrated stock positions. The most typical reasons are:

• They inherited the stock.
• They worked for the company.
• They (luckily) bought a winner and have seen it rise year after year.
• They are hoping the stock will have a turnaround and they will recover the losses.

We all know emotions can cloud our judgment. Investment decisions are no different. Removing an emotional attachment to a stock and parting ways on good terms, could create more of an opportunity for you. 

Sometimes we can hold on to something due to loss aversion because it hurts more to lose money. But this may not be in your best interest. As fiduciaries at Spark, it is our job to point out when something like this may be holding you or your portfolio back.

We want your money to work hard for you and not subject it to unnecessary risks. Concentrated stock risks fall in this category.

If you hold concentrated stock, then reach out to us and have a conversation to see if this stance still serves you well!