Just like most things in life, too much of a good thing can sometimes be bad for you.
The good news is, you have been acknowledged as a leader and a contributor within your organization. As a result, you have accumulated a significant amount of equity incentives. Due to your Associate Stock Purchase Program, Restricted Stock, Stock Options, Phantom Stock, Stock Appreciation Rights, and/or your retirement plan Employer Match consisting purely of employer stock, you now find your investment portfolio dangerously overweight in company stock. Given your primary source of income is also attributable to your employer, it might be time to consider a few strategies for lightening the load and diversifying your holdings to a less risky level. But where do you begin?
Step One: Define the Problem
Let’s start with the basic premise that it isn’t safe to put all your investment eggs into one basket. Studies have shown time and again that individual stocks are more susceptible to volatility, underperformance and potential loss than a well-diversified basket of securities. Historically, a properly diversified portfolio, aligned with the investor’s goals, risk tolerance, and time horizon, has proven to be less volatile, while still providing reasonable returns. When a single stock represents a significant portion of your portfolio’s overall value, the portfolio is, by definition, not well-diversified. This scenario can often lead to an investor taking on higher risk without a guarantee of higher returns. If you don’t expect to get compensated for the additional risk, there really isn’t any reason to accept it. We only need to consider the likes of Lehman Brothers, Circuit City, Freddie Mac, Kodak, Office Depot, Countrywide Financial, Sprint Nextel, Sears, Enron, Worldcom, and J.C. Penney to realize that even large, well-known companies can struggle and ultimately have a catastrophic impact on one’s net worth.
So, what is “over-concentration”? This is a great question and somewhat open to debate. There does not seem to be a general consensus as to exactly what constitutes too much of one specific stock in an investor’s portfolio. This is understandable given every investor is different. To answer this question, we should consider a number of factors such as the investor’s overall wealth level, the allocation of the portfolio, the investor’s needs relative to the portfolio, the investor’s time horizon, the investor’s tolerance for risk or volatility within the portfolio, income levels now and at retirement, and the types of income available. Many would also consider whether the investor is tied to the company in other ways such as it being their current source of income and benefits. If so, the investor has that much more to lose if the company fails and/or the stock tanks.
Step Two: Set a Realistic Goal
Everyone’s financial situation is different. It is important to set realistic goals relative to your starting point. Shedding a 25% position within a $10,000 portfolio isn’t the same as dropping 25% from a $10,000,000 portfolio.
In light of your circumstances, what do you want to achieve? How much company stock do you have and how much do you want to shed? Some would make the case that with all the low cost, highly diversified investment options available, holding anything more than one or two percent of your portfolio in a given stock would be considered excessive. However, since most experts would agree that anything over ten percent is likely to increase the overall risk of the portfolio without adding much in the way of expected return, let’s assume that ten percent would be a reasonable goal to shoot for. Is it ideal for everyone? Probably not. But even in a worst-case scenario, a ten percent drop in portfolio value due to one holding should not cause irreparable damage over the long-term.
Don’t forget to set a time frame for achieving your goal. Sometimes it isn’t possible to reduce your holdings due to specific company or plan policies. And sometimes it isn’t feasible to do so quickly due to potential tax liabilities. Whatever the case may be, consider the circumstances and determine a suitable time-frame for hitting your goal.
Step Three: “Weigh” Your Options (pun intended)
Investors wishing to diversify concentrated equity holdings have several options. Some of the more commonly considered options are:
- Re-Allocate or Liquidate – This option is the clear choice if a significant portion of your company stock holdings are held within your employer retirement plan like your 401(k). In these accounts, you can often re-allocate quickly and without tax implications. (Caveat: If you hold a significant amount of low cost basis company stock inside your qualified retirement plan and you plan to retire or separate from service soon, talk to your financial advisor or tax professional about “Net Unrealized Appreciation.” It might make sense to keep your stock due to potential future tax savings.) If all your holdings aren’t inside your employer plan, consider liquidating over a period of years to spread out the capital gains taxes over time.
- Borrow on Margin – One of the most common methods used to diversify away the risk associated with overconcentration in a single stock is to use your concentrated stock position as leverage to purchase other securities. This concept is called borrowing on margin. There are specific rules that must be followed, but all in all, it can be very effective in helping you move closer to your target portfolio allocations.
- Implement a Derivative Strategy – While these strategies can be a little more complex, they can be useful to protect against the downside of existing positions as you work towards longer term diversification. Utilizing an equity collar involves the adoption of a common hedging strategy using a combination of long-term put and call options. This approach can limit your downside risk of the stock, but it will also limit the potential upside return. A variable prepaid forward (VPF) is a forward sale of a “contingent number of shares.” Using a VPF will allow you to establish a certain dollar amount of stock that you will sell at some point in the future. This grants you the ability to borrow against the future proceeds in the present. Due to certain securities regulations, not all your stock exposure can be eliminated through this approach, but enough can be utilized to effectively diversify away some of your single stock risk.
- Utilize an Exchange Fund – This approach is used to help investors diversify a large holding of low cost basis stock by contributing the stock in-kind to the fund in exchange for a share of the other securities in the fund. You are able to instantly spread your concentrated position into a more diversified basket of securities. If done right, this strategy does not cause an immediate taxable event, but it does not eliminate the tax burden either – it only delays it. This strategy is not for everyone, however. You must meet certain thresholds for investable assets or net worth and remain in the fund for a minimum time frame (3-7 years).
- Make Charitable Gifts – There are multiple charitable giving strategies to consider, but they all have similar structures. When you donate your stock to a qualified charity, the value of the asset (along with its low cost basis and risk) is transferred to that entity. In addition to reducing or eliminating your concentrated stock risk, you will likely receive a tax deduction and potentially an income stream for life, depending on the strategy selected. If you are charitably inclined, this approach can be very rewarding. Variations of this approach can be implemented using Donor Advised Funds, Charitable Trusts, and Family Foundations.
As with all tax-related matters, it is recommended that the investor review the strategy with independent legal and tax counsel.
Step Four: Create a Plan
Use the following decision-tree to help determine the best approach to use in your unique circumstances:
- Are you attached to this stock and don’t really want to sell it (perhaps for sentimental reasons or because you have a “good feeling” about it)?
- If so, consider an option strategy if you want to use the stock to generate some additional income without selling outright.
- Or, if you aren’t concerned about generating additional income, consider using margin to purchase shares of other companies to further diversify your holdings.
- If you are not attached and don’t mind letting go of the stock, before you take any action, you should consider the tax implications of selling out of the position.
- If the tax ramifications won’t be significant, consider selling the stock outright.
- If there will be a serious tax burden to bear, consider donating the stock to charity. You would get a tax deduction and neither you nor the charity has to pay the tax bill upon sale of the stock. Everyone comes out a winner (except Uncle Sam)!
- If there are taxes and you aren’t feeling charitably inclined, you might consider selling out of the stock position over time to minimize the tax impact each year. Another option to consider would involve utilizing an Exchange Fund to diversify your holdings. There is typically a lock-in period (approximately 7 years), but during that time you will be spreading your risk out to other Exchange Fund participants. After your time is served, you’ll be able to trade in that risky stock for a more diversified portfolio.
If all this seems complicated, well, it is! But don’t worry, there are lots of useful strategies to consider. With the help of a qualified professional, you’ll be better equipped to avoid the landmines while shedding the risk of that overweight company stock portfolio.
Bob Harris, J.D., CFP®
This commentary is provided for general information purposes only and should not be construed as investment, tax or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.