Three Strategies to Reduce Concentrated Stock
When managing your investments, having too much of one thing can be risky—especially if that “thing” is a single stock or a handful of highly correlated stocks. You’re not alone if you’ve found yourself heavily invested in one company or a related group of companies. Many investors face what’s called “concentration risk.” In simple terms, this means that a large portion of your portfolio is tied up in a single asset, which can lead to heightened volatility and missed opportunities for diversification.
Several strategies reduce the risk associated with concentrated positions while balancing liquidity, tax considerations, and long-term goals. Let’s dive into the key takeaways and practical strategies you can use in your portfolio to keep risk in check without sacrificing potential upside.
What Is Concentration Risk?
Imagine your investment portfolio is like a fruit basket. If your basket is filled with only apples, a bad harvest could leave you with a significant loss. On the other hand, a mix of apples, oranges, bananas, and grapes spreads the risk. Concentration risk is the “all apples” scenario. When more than 10% of your portfolio is comprised of one stock, any downturn in that company can ripple through your entire portfolio.
Beyond the market risks, there’s also an emotional component. Many investors have deep ties to their concentrated positions—perhaps it’s a stock inherited from family or one tied to your career. This emotional attachment can make stepping back and looking at the bigger picture hard.
The Case for Diversification
Diversification is a powerful tool to reduce volatility. When you diversify, you spread your risk across different asset classes or industries. If one investment suffers, the others might hold steady or perform well, balancing your overall returns.
Selling off a concentrated position, however, isn’t always straightforward. Tax implications, trading windows, and personal biases can complicate decisions. That’s why it’s essential to have a clear, strategic plan.
Strategy 1: Creating Liquidity Through Stock Sales
One of the most direct methods to reduce concentration risk is gradually selling part of your position. This approach—often executed through systematic or time-based selling—can help minimize market timing risk. For example, setting specific price targets above and below your current stock price can create natural “exit points” over time.
Pros:
- Boosts liquidity
- Reduces risk exposure
- Improves portfolio diversification
Cons:
- Realizes capital gains immediately, which can trigger tax liabilities
- Might miss out on future upside if the stock continues to perform well
Strategy 2: Diversify Through An Exchange Fund
Exchange funds are another useful tool, particularly if you want to diversify without selling your shares outright. In an exchange fund, multiple investors contribute their concentrated stock positions into a common pool. In return, they receive proportional interest in a diversified portfolio. This is especially attractive for investors legally or emotionally tied to their holdings.
Pros:
- Helps you diversify while deferring taxes
- Avoids the public disclosure and market impact that can come with large stock sales
Cons:
- Often involves a lock-up period (sometimes as long as seven years)
- Acceptance into the fund is subject to the fund manager’s criteria, and shares may be valued at a discount
Strategy 3: Wealth Transfer Through Charitable Giving
Charitable giving can be a win-win strategy for those passionate about philanthropy and planning for the future. Options like donor-advised funds or charitable remainder trusts allow you to transfer some of your concentrated stock holdings to charity. This helps reduce your concentration risk, provides a valuable tax deduction, and helps you leave a legacy.
Pros:
- Generates immediate charitable deductions
- Avoids immediate capital gains taxes on appreciated assets
- Reduces the size of your taxable estate
Cons:
- You give up control of the donated assets
- The process can be complex, requiring guidance from tax and legal advisors
Other Options
Although not discussed in detail, you may also consider hedging your concentrated stock position with a zero premium collar. This strategy involves buying a put option (to protect against downside risk) while simultaneously selling a call option (which caps your upside). The beauty of this strategy is that it requires no net premium payment. Alternatively, if taxes are a concern, you may consider a variable prepaid forward. This approach allows you to monetize your concentrated position without selling your shares immediately. Essentially, you receive liquidity upfront while deferring capital gains taxes until a later date. This strategy allows you to diversify your portfolio without losing the benefits of owning the underlying stock.
We’re happy to discuss the pros and cons of these two strategies in further detail if you are interested.
Overcoming Behavioral Biases
It’s important to acknowledge that managing concentrated positions isn’t just about numbers and strategies—it’s also about emotions. Investors often hold on to a stock because they believe “it’ll bounce back” or due to a personal attachment. These biases can cloud judgment, making it hard to implement a well-thought-out plan. Recognizing these biases and working with a trusted financial advisor can help bring objectivity to decision-making.
In Conclusion
Reducing concentration risk isn’t about abandoning a winning investment; it’s about ensuring that one investment doesn’t become the Achilles’ heel of your entire portfolio. Whether you sell a portion of your holdings gradually, hedge your exposure with options, utilize tax-efficient strategies like variable prepaid forwards, or diversify through exchange funds and charitable giving, the goal is the same: to create a more balanced, resilient portfolio.
The strategies we’ve discussed offer a range of options to suit different financial situations, risk tolerances, and long-term goals. It’s all about finding the right mix that provides liquidity, minimizes tax impacts, and aligns with your financial plan. If you’re overwhelmed by the complexities of managing concentrated stock positions, remember you’re not alone. Working with a knowledgeable financial advisor can provide you with tailored solutions and the confidence to take action.
Ultimately, the key to success is a balanced approach combining careful analysis with a clear understanding of your objectives. By reducing concentration risk, you not only protect your current wealth but also position yourself for more stable and diversified growth in the future.
If you have a highly concentrated position, consider scheduling a call with us. Considering the risk and tax implications before you need the liquidity is paramount!
Please consult with your financial advisor and/or tax professional to determine the suitability of these strategies. All views, expressions, and opinions in this communication are subject to change. This communication is not an offer or solicitation to buy, hold or sell any financial instrument or investment advisory services.