Managing a Concentrated Portfolio Holding
“Success breeds complacency. Complacency breeds failure. Only the paranoid survive.” ― Andy Grove
The quote from the former CEO of Intel Corp. encapsulates the sentiment that investors should be paying close attention to if a single stock holding represents a large portion of their net worth. Following a decade in which equity markets have delivered stellar investment returns there is probably a degree of complacency causing investors to lose track of the goal of protecting family wealth and managing investment risks.
Risk that one event could trigger severe instability or collapse
The good fortune that comes from inheriting a large stock position from a family member or accumulating significant wealth through equity-based compensation does come with investment risks. It is generally agreed that once shares in a single stock represents over 10% of one’s portfolio, investors are exposing their portfolio to undue systematic risks tied to one company or industry. The importance of managing these risks become magnified when investors consider their risk tolerance, liquidity needs and their retirement goals.
Two reasons investors avoid diversification
There are two common reasons why investors defy the benefits of portfolio diversification and maintain a concentrated holding in their portfolio. The first reason is associated to range of emotional factors that can influence the investor mindset. Some investors refuse to sell until the stock price recovers to reach previous highs, while others do not want to sell because the stock has performed so well for them in the past. Very often the rationale is bound to the past and fails to consider the downside risks of holding a concentrated position into the future. The second reason is that investors simply do not want to see a portion of their wealth go towards paying taxes on capital gains.
The odds are in favour of diversification
The role for investment advisors that are dealing with investors willing to take on unnecessary risks with a concentrated position is to simply provide them with the facts. The probability of generating a higher return while taking less risk is higher if you hold a diversified portfolio than by concentrating your investment in a single stock. This was highlighted in a recent article published by John Rekenthaler at Morningstar that looked at 1,000 stocks in the Morningstar U.S Stock Index between January 2011 and December 2020. Rekenthaler found that only 49% of the stocks outperformed the less volatile Morningstar U.S. Government & Corporate Bond Index, and only 20% of stocks outperformed the well diversified Morningstar U.S. Stock Index itself. These are not favorable odds for anyone expecting to earn attractive returns without taking an elevated level of risk.
While we believe the argument supporting holding a diversified portfolio rather than a concentrated stock position is straight forward, the rationale to trigger capital gains and the impact of paying taxes is more complicated. There is no dispute that tax considerations should be evaluated in making investment decisions; however the goal of avoiding taxes from capital gains should not overly influence the investment merit of owning a stock. This is where the value of a trusted tax advisor can support in making decisions on the timing of reducing a concentrated position.
Tax Planning Options
A tax advisor will explore a range of factors on how best to reduce a concentrated position in a tax-efficient manner. Typically, an investor with a longer time horizon can reduce their position more aggressive as they will be able to recover the tax cost through compounding returns. In addition, a strategy to reduce a stock position can span several years and reflect an expected change in an investor’s taxable income levels as well as consider the impact of changes in capital gains inclusion rates. Investor can also lessen the tax burden by donating shares in kind to charities and by realizing stock losses to offset the gains.
Put and Call Option Hedging Strategies
There are other alternatives to managing the risk of a concentrated stock holding. First, is by using put and call option hedging strategies. There are different option strategies that can be executed that will limit stock price volatility of a holding. However, hedging strategies are complex and there are implementation costs. In addition, there may be tax implications that would need to be considered by a tax advisor.
Exchange the shares
A second alternative is to exchange the shares in a concentrated holding for units in an exchange fund. Exchange funds aggregate the concentrated stock positions of many investors into a diversified portfolio. The transaction allows investors to roll their shares in on a tax-deferred basis into a corporate vehicle, and in return receive units of a diversified portfolio of companies. This serves to reduce the systematic risk associated with their concentrated holding, and it defers the tax liability to when the investor redeems the units. Although exchange funds provide benefits from a diversification and tax deferral perspective, they do have limited liquidity and come with additional costs. Most importantly, an exchange fund may not provide the investor with a suitable investment portfolio.
The combination of hard work and good fortune has rewarded some investors with considerable wealth tied to a single holding in their portfolio. The challenge for those investors is to recognize the investment risks such a position may have on their family’s financial future. While the decision-making process may be difficult to manage given investment, retirement planning and tax factors, the support of trusted advisors can make the experience very rewarding.