Guest Post by Michelle Black, CIMA®, CPWA®

Michelle Black is a solutions portfolio manager with 28 years of investment industry experience. She holds a bachelor’s in business administration from the University of Southern California. She also holds the Certified Investment Management Analyst® and Certified Private Wealth Advisor® designations, is a member of the Investments & Wealth Institute and serves on the CIMA commission.

KEY TAKEAWAYS

• Many investors fail to realize the risks involved in holding concentrated stock.

• Even in years when the overall equity market rises, a significant number of stocks fall in price.

• Donating concentrated stock to charity can help clients avoid capital gains taxes while still benefiting from a tax deduction.

For investors who have either received a large inheritance or worked at the same company for a number of years, there’s a chance that much of their wealth is tied up in a single stock. This, of course, is rewarding when shares of the company are rising, but may expose them to significant risk should the price drop unexpectedly.

There is no single definition of “concentrated stock,” but a broad rule of thumb is that any position making up more than 10% of a portfolio should be reviewed for appropriateness. Not every concentrated position needs to be sold off. Indeed, it may be possible for an investor to continue to hold a sizable amount of one stock if their portfolio also has a solid foundation of well-diversified investments to help meet their goals. But in most cases it is important to recognize the value of a well-rounded approach.

It can be difficult to convince investors who have benefited significantly from concentrated stock positions to lighten their positions and broaden their holdings. Aside from the pure monetary gains, investors may have emotional ties to a company at which they or a family member worked. Nevertheless, I have found over the years that stressing a few key points can help clients understand the risks of concentrated positions and make clear why a more diversified approach is generally best.

Single Holdings Add Significant Investment Risk

As you know, company-specific risk can be a far bigger danger over the long term than general market risk because, while the broad market has historically bounced back from declines, many individual stocks have not. Business-specific risk is especially pronounced among smaller companies, but a large number of established blue chips have also been undercut by forces ranging from short-sighted management to shifting market trends to accounting scandals. Among the more prominent casualties: Lehman Brothers, WorldCom, Enron, Washington Mutual and Circuit City.

In fact, only 54% of companies in the Fortune 500 in 2000 are still on the list today. The rest have either gone bankrupt, merged with another company or simply fallen from the ranking. By one estimate, a mere 12% of companies on the Fortune 500 in 1955 were still on the list 59 years later.

A Rising Market Doesn’t Mean Every Stock Moves Higher

Of course, the stock market rises more often than it falls. Over time, the S&P 500 has advanced in 75% of rolling one-year periods since 1926. But it’s easy to overlook that even in years when the market itself is up, not every stock follows suit. In 2015, for example, the S&P 500 had a return of 1.4%, but half the stocks in the index were down on the year. In 2016, the index had a return of nearly 12%, but just about one quarter of stocks fell.

A Rising Tide Doesn’t Lift All Boats

Even in years when the market itself rises, a significant number of individual stocks do not.

Importantly, investors need to understand that volatility tends to be higher for individual stocks than for the market as a whole. The average stock in the S&P 500 is twice as volatile as the index itself, and stocks of smaller companies tend to fluctuate even more. Understanding a stock’s volatility is important partly because it can affect the timing of a sale.

One of the biggest concerns investors have about concentrated stock centers on taxes. There’s no doubt that an investor with a low-basis position in a stock held for many years could face a sizable tax bill when selling shares. However, the tax impact must be put into context. The maximum long-term federal capital gains tax rate is currently 20%. Upper income wage earners are subject to an additional 3.8% net investment income tax, although this tax is assessed only on the gain realized, not the entire value. Still, you should measure the total potential 23.8% tax hit against the possibility of a stock losing one quarter or more of its value, which can be a very real possibility in a market sell-off.

Consider Alternatives to Outright Selling

Of course, there are instances when it may not be advisable to liquidate a concentrated position. For example, for investors in poor health or who are advanced in age, it may be more tax-efficient for their heirs to diversify after receiving a step-up in cost basis following the investor/s death.

Investors may want to consider the benefits of donating concentrated stock to charity instead of selling. I’ve found clients are eager to learn about how they may be able to avoid paying any embedded capital gains tax while benefiting from the tax deduction. You may also point out that giving some shares to charity can be done in conjunction with selling their position, thus having the charitable income tax deduction potentially offset taxes from the sale of shares.

Investors should understand the importance of analyzing the range of options available and examining the totality of their finances, including time horizon, risk tolerance, spending needs and financial goals. Each investor is different, but I find that walking them through the basic facts explained above helps them to better understand the risks involved in concentrated stock and the great value in deploying those proceeds into a more-diversified portfolio.

Your Concentrated Stock & Portfolio Allocations

If you have questions about your concentrated stock position or your portfolio allocations, please contact me to discuss your individual situation and goals.

This post adapted from material provided courtesy of Capital Group.