Who among us has not been warned against putting all of our eggs in one basket? This wisdom, handed down through the ages, reminds us that success often depends as much on our ability to manage life’s risks as it does to seek life’s rewards.
The fact is that through much of our lives, in most of life’s aspects, we are in fact highly concentrated. After a few years of general study, for example, we settle down and concentrate our knowledge in a specific area, be it engineering, medicine, business or some other field. If we don’t do so in school, the workplace pushes us in this direction. We may progress from laborer, to heavy equipment operator to specializing in a particular piece of equipment.
We concentrate our affections, when we say “I do,” after hearing the better and worse line. Our real estate holding are usually limited to one zip code.
I do know for sure that in the area of our financial lives, it’s imperative that we manage concentrated risk. While it’s not limited to investments, we often find people are taking far too much risk in their retirement and investment accounts.
The most common way people find their investments concentrated is in a company 401k plan. Many companies matched contributions in employer stock and many people put their contributions into employer stock as well. It’s not uncommon to find a person with more than half of their invested wealth in a single company.
People may also find themselves with a large amount of stock due to an inheritance, the purchase of company stock through an employee stock purchase plan or systematic investing in a dividend reinvestment plan. It’s never a bad thing to own the stock of great companies. But it is possible to have too much of a good thing. Especially if that good thing turns not so good.
Stock prices move quickly and significantly, sometimes when the market is closed and retail investors have no way to get out. I don’t need to name companies, but there have been some high profile disasters for rank-and-file employees in the last few months and years.
Investors have many good options to diversify their investments and spread risk. Inside employer-sponsored 401k plans, there are no tax consequences for selling and the trading costs may be paid by the employer. Many 401k plans offer diversified investments in most asset classes where a single selection will offer ownership in hundreds of companies. The company stock you sell may very well be one of the companies, but it will be joined by many, many more.
Stock positions in taxable accounts can offer more challenges. Sometimes the challenge is emotional, when the stock was acquired through inheritance. Often it’s a tax issue. People know they should diversify a position, but selling often triggers a tax on the gain.
There is no best way to deal with emotions. One strategy, however, is to determine the amount of shares the individual originally purchased and sell down to that number. One can also keep a token amount of stock in honor of the grantor.
As for taxes, we must always remember that we pay taxes only on the gain, not the entire amount. Under current tax laws, the maximum capital gains tax rate is 15 percent federal plus applicable state tax, which in Connecticut is an additional 5 percent. Market fluctuations, in contrast, affect the entire value of the stock. They can be severe, wiping out in a day far more than taxes would have claimed had the position been trimmed. Investors must also remember that they will have the cash to pay the taxes by reserving a portion of the sale proceeds.
Concentrated stock can be addressed by hedging, selling or gifting. A hedging strategy entails setting floors on the price at which one will keep the stock. The best way is through options, and it requires attention as well as expense.
Selling the stock is generally straightforward. One exception might be for a person who is an executive and considered a control person of the company. In that case they may have to establish a systematic plan.
Investors can pool large positions into exchange funds, which are vehicles that allow many people with concentrated positions to come together and pool their shares. There are risks and costs associated with such pooled funds that need to be fully evaluated before entering such an arrangement.
People should also consider the charitable option, especially if they are currently giving cash to a church or charity. If they gift stock, the charity can sell it and pay no tax due to their tax-exempt status.
There is no single-best way to manage the risk of a concentrated stock position. Thankfully, there are many good ways to do so. The one that’s best for you will depend on your individual circumstances.