When Success Becomes Risk: Managing a Concentrated Stock Position

Wealth Creation vs Wealth Preservation

There is no clear moment when an investor crosses the line between wealth creation and wealth preservation. Responsibilities often lead to a time when one has more interest in keeping something over losing it, and this will likely be different for each person. A key reality of wealth preservation is that it does not mean a sacrifice of growth. Wealth preservation is not the elimination of growth; but it is a shift in risk perspectives from one goal to another. The transition from wealth creation to wealth preservation rarely happens on a single day. It happens gradually. Early in life, taking risks may feel necessary to build wealth. Later, when that wealth is tied to retirement security, family goals, charitable intent or legacy planning, the question changes. It is no longer simply, “How much more can this grow?” It becomes, “How much am I willing to risk losing?”

When Concentration Becomes Risk

Concentrated positions are rarely just numbers on a statement. They often carry a story. A concentrated stock position may represent a long career, a company someone helped build, an inheritance from a parent or an investment decision that changed a family’s financial trajectory. That history matters. It also makes the decision to reduce the position more difficult. Selling can feel like disloyalty, regret or a lack of confidence in the very investment that created good fortune. A prudent plan should acknowledge that emotion while still evaluating the risk objectively.

Some families need to evaluate the concentration at the household level rather than simply within one account. A family may own company stock in a brokerage account, receive compensation from that same company, participate in deferred compensation plans, hold employer retirement benefits or even have future business opportunities tied to the organization’s success. Viewed independently, each exposure may appear manageable. Viewed together, however, a family’s financial future may be significantly more dependent on one company than they realize. Concentration risk is not always found in a portfolio statement; it can be embedded throughout a family’s entire financial life.

The risk is that your wealth can be dominated by a single name. The obvious issue with a concentrated position is that your portfolio risk becomes tied to the risks of that one company. Names like Enron and MCI WorldCom become ominous warnings of what can happen when one name goes through decline. Concentration risk is not limited to catastrophic failure, however. A company does not need to become Enron or MCI WorldCom to damage a financial plan. It may simply mature, slow, underperform or stop generating the growth a family needs from its portfolio. Keep in mind that even dominant companies are not immune to disruption. Changes in technology, regulation, competition, consumer preferences or management quality can alter a company’s trajectory in ways that are difficult to predict. Investors often assume the future will resemble the recent past, but history suggests otherwise.

Without growth, it becomes a wealth destroyer of a different kind. Wealth is eroded over time as returns cannot grow enough to overcome the distribution needs of the portfolio. No matter how the position came about, diversification away from the risk of one asset is an effective way to reduce the overall risk of your assets. But diversification comes at a cost.

Dealing with a Concentration

There are many strategies that exist to achieve diversification benefits. If the asset being held is a controlling interest in a family-owned company, there could be additional benefits to maintaining the asset through generations. When that situation occurs, there needs to be estate planning to effectively shepherd the asset from one generation to the next while minimizing the taxes paid. But if the asset is just a publicly traded company in your portfolio that happens to be in a concentrated position, the situation is noticeably different. In that case, say you bought a tech company 30 years ago and it has just grown into a concentrated position, then there are a couple of considerations, and they are generally centered around tax.

Sell the asset and pay capital gains tax on the gain of the sale.

Hold the asset until it goes through estate settlement. Assuming it is in the taxable estate, this could lead to estate tax on the value of the asset even if the capital gain tax is avoided due to a step-up in basis at death. In some cases, the estate may be forced to sell the asset to pay the estate tax.

So, it really boils down to whether you should deal with the concentration now or later. That question is rife with additional considerations around your longevity and health, in addition to the health of the markets, the company and your risk appetite. Dealing with taxes today is visible, immediate and measurable. The risk of continuing to hold has less certain and less immediate effects. As a result, many investors become trapped by what might be called “tax paralysis” or the tendency to focus so heavily on the known cost of selling today that they lose sight of the risks associated with continuing to hold the position. Knowing exactly how to proceed is difficult, but there are some thoughtful approaches that can be part of a diversification strategy.

Gradual Diversification

The most straightforward approach is to follow an annual plan of systematic sales. This process identifies a reasonable tax bill and sells shares to reduce the concentration each year. Your wealth management advisor would typically employ quarterly sales enabling better tax planning as well as a dollar-cost-averaging of the reduction. Proceeds from sales are redistributed into a diversified portfolio. The goal is not necessarily to eliminate the position entirely. Rather, it is to reduce the possibility that a single investment can disproportionately influence the family’s ability to achieve long-term goals.

1. Dividend Redirection: Many times, investors have plans in place to purchase more of a stock using the dividends it produces. When the asset has grown to a concentrated level, turning this system off and using proceeds to buy the diversified portfolio is a non-taxable way to reduce concentration growth. It could produce reduction in concentration as well, but at the very least it will slow the concentration growth rate.
2. Charitable Giving: Giving the asset to charities (or placing it in a donor-advised fund for future deployment) is great way to accomplish philanthropic goals while also reducing portfolio risk. Many investors continue giving to their preferred charities from cash. Provided the recipient is a 501(c)(3) capable of receiving in-kind stocks, giving the appreciated shares reduces your tax burden while also reducing your risk exposure in the portfolio. Charitable giving can be highly effective, but it is important to remember that donated shares leave the portfolio permanently. Unlike a sale, where taxes reduce but do not eliminate the capital available for reinvestment, a charitable gift removes the full value of the donated shares from the family’s investment base. That may be perfectly appropriate when philanthropy is a priority, but it should be coordinated with the family’s broader financial plan. Charitable Remainder Trusts (CRTs) are a way to gift the stock but also receive benefits for a period of time. CRTs can be highly effective when a need for income is present, but there is no free lunch! Capital gains in the CRT are still doled out with the income received. However, any gains that remain undistributed in the CRT will not be taxed when the term ends and the assets flow to the charity.
3. Risk Reduction: There are many times when it is easy to recognize the risks inherit in holding a position. Generally speaking, there are ways to offset risk without full asset disposition, providing a safety net against the worst-case scenario while not realizing the gains of an outright sale or losing the control of the asset through charitable giving.
   1. Hedging employs purchased puts to set a floor on assets. These floors can be expensive, so some strategies sell calls to offset the cost of the puts. This approach is a “collar” which limits the risk but also limits the upside potential.
   2. Monetizing the position involves using the asset to generate proceeds without a sale. Covered Calls are a strategy that provides liquidity, however there is also the risk of “being called away” and losing the position. Loans against the position are another viable way of creating liquidity.
   3. Diversification can be achieved without outright sales using more complex methods. Variable Pre-Paid Forwards (VPFs) offer diversification advantages but will require gains to be realized at a future date. However, the nature of the contract often allows for immediate diversification. Additionally, some investors can benefit from the use of exchange funds where they contribute their concentrated position to a fund and receive shares in a diversified basket in return.

The Approach Matters

Ultimately, the big question is often the wrong question. Instead of asking, “should I sell this stock?” perhaps consider, “should my family’s future depend on this one company?” One of the biggest hinderances to evaluating the position is the fondness we feel toward the decision to buy the stock in the first place. But the family’s future wealth picture is now dependent on the decision to sell and timing of selling the stock. It is a different mindset. A concentrated position may have helped build wealth but preserving that wealth often requires a broader foundation.