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Back in 2007 I worked for a large bank. One of my co-workers was a long-time bank employee – he had been through many mergers and he really believed in the capabilities and future success of the bank. One day he told me he had his entire 401(k) in bank stock, and at the time, he suggested another co-worker invest her 401(k) heavily in bank stock.

Editor’s Side Note: With 100% of his 401(k) in his employer’s stock, my co-worker had a huge concentrated stock position. Typically, a concentrated stock position is when more than 7% of your portfolio is invested in a single stock. This introduces greater risk into your investment portfolio that you, as an investor, may not be “paid” for in the form of higher returns.

OK, back to the story.

After he went about his business, I told my co-worker, who was seeking help with her 401(k), that investing too much money in one stock was not a good idea.

This was hard advice to take because, at the time, bank stock was at all-time highs. My co-worker who claimed to have 100% of his 401(k) in bank stock would have experienced enviable returns. He seemed like an investing genius.

As you may be able to tell from the title of this post, things didn’t end well.

Here’s a graph from Yahoo Finance showing the trajectory of the stock from 2001 to May 2019.

Yikes.

The Thrill of Victory. The Agony of Defeat.

When my brother was younger he owned a set of VHS tapes about athletes who were experiencing the “thrill of victory” showing amazing feats of skill and perseverance. The other tape was a cringe-worthy foil to that video called “The Agony of Defeat.” In this video tremendous athletes were caught on tape wiping out. (It’s actually available on a major online retailer if you have a VHS player laying around.)

The bank stock was kind of like that video series. The graph above compares the bank stock (dark blue) to the S&P 500 index (a broad market index made of 500 large and mid-sized companies in light blue). The graph starts in 2001 and until 2007 – 2008 the bank stock crushes the S&P 500. The thrill of victory!

Then the housing market crashes. And so does the bank stock. Hard. From its high of just above $54 to a low of about $3.14. It was brutal. As you can see from the graph above, if you held on to the stock through the crash and subsequent recovery you would still be worse off today, over 10 years later, vs. investing in the S&P 500 Index.

This story gets worse before it gets better.

My co-worker who claimed to hold his entire 401(k) in bank stock was close to retirement. While the stock price was falling toward the low single digits we also went through a round of significant lay-offs. Many of the older employees were “voluntold” to retire, including my co-worker.

On the bright side, many of the older employees had pensions to supplement their retirement savings and the bank did not go out of business – so their pension was preserved.

Let’s take a closer look at the math on this investment.

Let’s just say (to make the math simple) my co-worker owned the equivalent of 10,000 shares of bank stock. We are also going to exclude any dividends paid during this time. If he owned 10,000 shares of bank stock in 2007 his 401(k) would have been worth about $540,000. Assuming he didn’t purchase any new shares of bank stock between 2007 and 2009 his 10,000 shares were worth $31,400 at their low.

If he “held on” and never sold his bank stock today, over 10 years from the market lows, those 10,000 shares would be worth about $300,000. Still well below the stock’s value in 2007.

Not only that, but the S&P 500 index (a diversified basket or large and mid-sized US companies) significantly outperformed over the last 10 years with less than the typical risk associated with holding a single stock position as measured by standard deviation.

The chart below shows the bank stock in dark blue and the S&P 500 index benchmark in light blue from 2009 until May of 2019. For reference, the stock market bottomed in March 2009.

*This is not investment advice. Talk to your financial advisor before making any changes to your portfolio.

Concentrated Stock Performance & Risk

You may be wondering, why does this even matter? Sure, your co-worker got hammered, but I really know and understand the company that I hold a concentrated stock position in.

Great question.

First, I would like to point out the behavioral finance bias known as the “familiarity bias.” This is the predisposition for us to invest in what we know because it’s comforting. We tend to underestimate the risk of the familiar investment and overestimate the potential return. This video does a great job explaining familiarity bias in 1 minute 30 seconds.

Now, a few comments on stock performance and risk.

Let’s start with stock performance. Typically, the performance of the overall stock market index tends to be driven by just a handful of companies. We never know which companies will do well in any given year.

If we don’t own the handful of companies that outperform, our actual stock performance can vary widely from the index.

A relatively small number of stocks drive stock market performance.
Used with permission of Dimensional Fund Advisors

More on Risk

Generally speaking, the riskier the investment the higher the return investors will demand. However, there are two broad types of risk when we talk about investing: “systematic” risk and “systemic” risk.

Systematic risk is also known as “undiversifiable risk” and is the risk investors bear by virtue of being in the stock market. There’s not much you can do about this risk (other than diversify into bonds, cash, real estate, etc.).

Systemic risk is also known as “diversifiable risk.” (See where this is going?) Systemic risk can be mitigated by making different decisions. Frankly, even if you hold less than 7% of your portfolio in a single company, you are still going to be heavily affected by the performance of that company.

Investors are frequently not paid very well for taking on additional systemic risk.

So why do it?

Concentrated Stock Positions: How They Happen

Most concentrated stock positions I see are a double whammy. They’re owned by someone who also works for that company; thus, they tend to have an emotional attachment to the stock. On top of that, their income (or pension benefit) may be derived from this same company.

If something were to go terribly wrong with that company you could be out of a job and facing huge stock market losses, just like my former co-worker.

Employees don’t always choose to have a concentrated stock position. Sometimes it accrues by accident. Here are some ways employees may be overexposed to a single stock:

  1. The company match in their 401(k) is paid in company stock. *
  2. They receive Stock Options as part of their compensation package.
  3. They participate in an Employee Stock Purchase Plan.

While none of these ways of owning corporate stock are a deal-breaker, you need to consider the multitude of ways your financial life may be tied to your employer (or former employer).

*Many employees don’t realize they can diversify out of their employer stock within their 401(k). If your employer pays your 401(k) match in employer stock you can sign-in and trade out of it as soon as it hits your account.

**This is not investment advice. Talk to your financial advisor for advice that is specific to your situation.

Inheriting Concentrated Stock Positions

I’ve also seen a number of people who inherited a stock (typically a local company) to which they also have an emotional attachment. If they’re really “lucky,” their father or husband told them on his deathbed to never sell XYZ stock, and now they are terrified of going against his deathbed wish.

Yes, that happens.

This is a terrible (though often unintentional) burden to place on someone. If you have been on the receiving end of such advice, you have my permission to silently thank your loved one for their heartfelt advice and then gently set it aside and do what is right for you.

Addressing emotional attachments

Perhaps you really believe in your company’s mission and the people you work with every day. You know them to be good, smart, hard-working people. How could the firm not be successful?

Or perhaps your granddaddy always loved XYZ company. He worked there and put the whole family through school on that salary. Your family owes that company your loyalty, right?

These kinds of loyalties can lead people to take on more risk than they realize because it doesn’t “feel” risky. You feel like you really understand that business. Do you understand the corporate balance sheet? Do you know their corporate strategy? Do you know if the corporate strategy is a good one? What are all the market headwinds that the company may be facing? Disruptive technology coming down the pike? How are their competitors faring?

The reality is that most of us don’t know all of the answers to these questions. Which is why we shouldn’t place all of our eggs in one basket. Or even most of them.

A company can be a great company but have below average returns. Remember, in any given year much of the stock market’s returns are generally driven by a handful of out-performers.

This is not an either/or proposition. You can acknowledge the wonderful things that have been brought to you from a particular investment and choose to diversify your holdings as you move forward to protect yourself.

How to diversify a concentrated stock position

What are your options when it comes to diversifying out of a large stock position? Often, one of the reasons why people stay in a concentrated stock position is because there may be significant adverse tax consequences to selling the position.

*Important: This is not tax advice. Please speak with your CPA or tax preparer to address your personal situation.

Fortunately, some witty financial planner out there came up with a simple acronym to sum up the different strategies an investor can use to diversify out of a concentrated position.

HOPES

As in, I hope(s) this stock position doesn’t tank before I get it under control.

(Don’t worry folks, I’ll be here all night.)

HOPES is an acronym and stands for the following tactics:

Hold on to some

Options

Planned Giving

Exchange Fund

Sell Some

In case you’re wondering, Planned Giving is a fancy way of saying “give some away.” However, HOGES doesn’t have quite the same ring to it.

The reality is, you may want to include several of these strategies as part of your concentrated stock reduction plan. You may also want to use different strategies depending on what type of account(s) the stock is held in and a whole host of other factors including (but not limited to) age, health, risk tolerance, and tax bracket.

Concentrated Stock Positions: Hold On To Some

How large of a position should you hold on to? This is highly dependent on your situation. Some things to consider:

What other investments do you hold in your portfolio?

How much risk are your comfortable with?

How much risk can you afford to take?

What type of company or industry does the stock represent?

Most investment firms will make you sign off on any stock position that is larger than 7% of your portfolio.

Also, don’t forget that your other investments (mutual funds, ETFs, etc.) may hold the same stock you are holding. Your overall exposure to a particular stock could be much higher than just what you own outright.

Talk to your financial advisor and figure out what your true exposure is to a particular stock.

Why might you hold on to a concentrated stock position?

Let’s say that Joan is 85 years old and holds a large position of ABC stock in a taxable account. Let’s be frank, Joan’s life expectancy is likely coming to a close. When she passes, her heirs could receive a significant step up in basis. Said plainly, the tax basis of the stock will rise to the value of the stock on the day that Joan passes away or an alternative date after her death selected by her estate executor.

We don’t need to get into the weeds too much here, but an example may help.  Let’s say Joan owns 100,000 shares of ABC stock which she purchased over the years for $5 a share. Now, XYZ stock trades for $15 a share.

Current XYZ stock value $1,500,000

Joan’s Basis in XYZ stock (what she bought it for) $500,000

Joan’s total long-term capital gain would be $1,000,000 (what she would be taxed on)

Since Joan is 85 she likely collects Social Security and perhaps has an IRA from which she takes a Required Minimum Distribution. If Joan were to sell all of that stock at one time she would pay a top rate of 20% long-term capital gains tax on the $1,000,000 gain. Combined with the Medicare Surcharge tax (3.8% on income above $200,000 for a single taxpayer), Joan would net less than $1,300,000 after taxes on a $1,500,000 stock position. If her state charges a capital gains tax, she would have to pay that as well.

Since Joan is 85 a large capital gain may cause her Social Security benefits to become partially taxable and it would likely push up her Medicare premium rates. As you can see, there are a number of trickle down effects from selling a large concentrated stock position all at once.

Let’s say Joan passes away and the stock is still trading at $15 a share. Her daughter inherits the stock, except now, her daughter’s cost basis is $1,500,000. If her daughter sells the stock she won’t owe any capital gains tax on the sale unless the stock price moves up from $15/share.

That’s potentially more than $200,000 saved in taxes. However, the concentration risk in the portfolio still exists. The potential loss in value from stock market volatility may be far more than what you could save in taxes.

This doesn’t have to be “all or nothing.” It might make sense to hold some of the concentrated stock position for a time rather than sell it all.

Concentrated Stock Positions: Options

People get excited about the idea of options. In reality, options can be expensive and cumbersome. However, so can selling a huge stock position with a large capital gain. Options can be a good choice for someone who wishes to hold on to a concentrated stock position for a period of time but doesn’t want to continue holding all of the risk.

I do not recommend that individuals buy options on their own. Yes, there are websites advertising “easy” options trading, but you can also find websites selling shirts for your cat. Just because you can buy it online doesn’t mean you should. Option strategies can be pricey and come with their own risks.  

Some employers place restrictions on their employee’s ability to hedge (buy options on) their employer stock. Be sure you understand the rules around using options at your workplace before pursuing an options strategy. Options can make sense in specific situations.

Talk to your tax preparer and financial advisor to see if options might be a good strategy for you.

Concentrated Stock Positions: Planned Giving

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Many people make charitable contributions. Most frequently, they donate via a check around the holidays. However, there are far more tax-savvy ways to donate to your favorite charity. One of my favorite ways to donate to a charity is to gift the charity appreciated stock, mutual funds, or ETFs.

The beauty of this strategy is that you can give the same amount of money to the charity (they don’t have to pay capital gains taxes on the asset you donated) and you can rebalance your portfolio tax free.

Here’s how it works:

Let’s say you want to donate $10,000 to your favorite charity this year. You get ready to write a check but decide to call your Certified Financial PlannerTM first. She suggests you donate some of your stock portfolio directly to the charity and replace that stock position with the cash you were going to gift.

You give her some information about where to send the money and she handles the transfer for you. She also handles the reinvestment of the cash into your portfolio to make sure your investment strategy still aligns with your goals.

Easy.

If you are charitably minded, a donation of part (or all) of a concentrated stock position can be a satisfying way of reducing the risk a concentrated stock position brings into your investment portfolio.

If you have a particularly large concentrated stock position but still need some income generated by the investment there are a variety of Charitable trusts that may make sense. Your estate planning attorney and financial planner can help you think through your options.

A wrinkle under the TCJA tax law means that it may make sense to “bunch” your charitable contributions into one tax year, even if you prefer to donate over time. In this case a Donor Advised Fund may be an elegant solution to help you achieve your goals. Keep in mind there are limits on charitable deductions based on your income. Talk to your CPA or Certified Financial PlannerTM more details.

Concentrated Stock: Exchange Funds

An Exchange Fund allows clients with large concentrated stock positions to contribute their concentrated stock in exchange for units of the fund. This allows you to diversify your concentrated stock position without incurring any capital gains until you sell the units in the Exchange Fund.

Typically, you are required to commit to the Exchange Fund for seven years. When you leave an exchange fund you will be issued shares from the fund, not cash. Your shares will be a mixture of all of the other investments contributed to the fund.

An exchange fund is not the same thing as an Exchange Traded Fund or “ETF.” They are an alternative investment in terms of access to your money and the requirement that you be a Qualified Investor with a liquid net worth of $5 million dollars.

The Downsides to an Exchange Fund

Exchange funds have high minimum investments (typically $500,000- 1,000,000).

A portion of fund investments will be illiquid.

Exchange Funds are required to hold at least 20% of their assets in illiquid investments. Illiquid investments are generally not publicly traded and can be hard to sell or value.

You don’t have control over the other investments.

The Exchange Fund manager will make the decision on what shares of which companies will be accepted and you may end up owning stocks you wouldn’t normally select. If you are a socially-conscious investor you may end up owning companies whose business model does not align with your values.

When you leave the Exchange Fund you will receive a pro-rata share of all of the investments in the fund at that time.

Exchange Funds tend to have long lock-up periods.

During the lock-up period (i.e. 7 years) you can’t access your capital or if you do, you may have to take back your shares and pay a heavy penalty.

Lost dividend income

Often Exchange Funds do not pay out dividends but rather reinvest those dividends back into the fund.

When do Exchange Funds make sense?

First, you have a really large concentrated position; many exchange funds have minimums of $500,000 – $1 million dollars.

Second, you are a qualified investor (you have $5 million in investible assets or more).

Exchange funds require that participants have a high net worth (over $5 million) or a high annual income (over $200,000).

Third, you don’t need to reduce your equity exposure or could reduce it elsewhere in your portfolio.

In other words, while you want to diversify out of your concentrated stock position you don’t need to reduce your total stock holdings overall or you can rebalance elsewhere in your portfolio to reduce your total stock holdings.

An Exchange Fund might also make sense if an investor in declining health wishes to diversify out of a concentrated stock position but they want their heirs to benefit from a step-up in basis at their death. An exchange fund can help such an investor meet these dual goals.

Concentrated Stock Position: Just Sell Some

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Simple, but not always easy. Generally, investors with a concentrated stock position need to take a variety of approaches to reducing their concentrated position. Sometimes it makes sense to simply sell a chunk of it.

This is particularly true for individuals who have amassed a concentrated stock position, at least partially, in a 401(k) or IRA. Perhaps your employer matched your contributions in 401(k) stock (remember, just because your employer matches in employer stock does not mean you have to hold it). Or perhaps you were really passionate about your employer’s mission and were active in the management of the company and you chose to buy your employer’s stock.

If part of your overall concentrated stock position reduction plan includes selling some stock, it’s important to set up a plan laying out the details around the sale. When will you sell the stock? How often will you sell it? How much will you sell at one time?

It’s likely at some point down the road when you go to sell a portion of the concentrated stock position it’s going to feel like it’s “not the right time.” Frankly, it may not be a great time. However, the purpose of this plan is to take the emotion out of the decision-making process.

Let’s not lose sight of an important point: holding 7% of your portfolio in a single company still poses a large risk to your portfolio. A good portion of your portfolio’s return will be dictated by a single investment.

Concentrated Stock Positions and HOPES

Now that you have an understanding of what a concentrated stock position is and ways you can diversify out of it, it’s time to take action. Should you hold on to some? Hedge your risk using options? Donating concentrated stock as part of planned giving strategy? Contributing some or all of your shares to an Exchange fund? Or determining when and how much to sell.

A fiduciary financial planner can help you figure out which strategies make the most sense in any given year and in relation to your overall financial plan.

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