If your portfolio is concentrated in one security or a narrow group of stocks, it can result in significant investment risk.
Strategies to help diversify your portfolio or manage the risk of concentrated positions include slowly liquidating your shares, hedging your holdings and gifting highly-appreciated securities to charity.
A financial professional can help you determine the strategies that are best suited to your financial plan.
It may be tempting to concentrate your portfolio on a high-flying stock or two, especially if you work for a corporation that offers an opportunity to include company stock in a retirement plan or to access shares as part of their compensation package.
However, even if the positions in your concentrated portfolio are performing well, the danger of a substantial drop is real. “Having a large position of any one stock in your portfolio is risky,” says Rob Haworth, senior investment strategy director at U.S. Bank. “While it has the potential to generate growth over time, it’s difficult to manage the risk that can occur with a concentrated individual stock position.”
Concentrated positions are common among principals of a company who hold a significant ownership stake. “It often can involve legacy wealth, where family members have assumed control of a large position in a company founded by previous generations,” says Bill Merz, head of capital market research at U.S. Bank.
“You want to pay attention to how you exit a stock, any potential downsides to doing so, and the investment objectives you’re trying to accomplish.
Rob Haworth, senior investment strategy director at U.S. Bank
Simply stated, concentration risk is when a single security or even a particular sector of the market comprises a significant portion of your portfolio. Even if you’re attracted to a particular stock or a strong-performing segment of the market, your portfolio becomes highly dependent on the performance of that individual component of the broad investment universe.
Such investments may fall behind broad market indexes, especially in certain market environments. Additionally, sector leadership often rotates through phases of the economic cycle, perhaps leaving you with a portfolio falling behind the broad market.
In a market where you can choose from thousands of investments, ample opportunities exist for you to diversify your portfolio and reduce concentration risk.
The potential downside of holding concentrated positions is summed up in the old saying “don’t put all of your eggs in one basket.” A negative, often unforeseen development could affect the value of that investment, perhaps resulting in a significant setback in your effort to achieve your most important financial goals.
“Specific events can alter the trajectory of a particular holding,” says Merz. “Consider, for example, that cruise line stocks declined dramatically when COVID-19 emerged and forced those businesses to halt operations for an extended period of time.” Investors who owned a concentrated position in such a stock would have experienced a dramatic decline in portfolio value. Merz notes that it doesn’t always require an unusual event to create serious investment risk. “Many blue-chip companies experience large stock price declines from time to time despite their high quality,” says Merz.
Fortunately, you can slowly and methodically mitigate concentrated portfolio risk. “You want to pay attention to how you exit a stock, any potential downsides to doing so, and the investment objectives you’re trying to accomplish,” says Haworth.
Following are six strategies that offer the opportunity to reduce concentration risk in your portfolio, as well as potentially reduce asset risk or tax penalties. In some cases, a combination of strategies may work best for you.
1. Slowly liquidate your shares
Selling a position, particularly a significantly appreciated position, will have notable tax implications. You can gradually diversify your portfolio by selling over time while helping to minimize risk and effectively manage the resulting tax liability. Your liquidation strategy could be designed to spread the tax liability over a number of years.
2. Minimize your portfolio risk by hedging your holdings
If you want to keep your current positions intact, consider strategies that use option contracts, which may help reduce your downside portfolio risk. One benefit of maintaining your concentrated position is that you avoid the potential capital gains tax liability that could result from selling.
The cost? You may have to pay out of pocket to buy the options, limit the potential price appreciation of your shares over a predetermined amount of time, or both. Depending on the circumstances, there may also be tax considerations.
3. Use covered calls
Another option strategy is to use covered calls. This centers around selling call options at a strike price higher than the stock’s current trading price. It may be an effective way to generate incremental income along the way.
If the stock price falls or its price remains flat by the time the call expires, you keep the premium, which partially offsets any potential price decline. If the stock rises, your upside is limited to the strike price established when the call was purchased. Depending on the strategy, the stock may be sold at the strike price, which also has related tax implications.
“Covered calls have the effect of capping potential appreciation for your stock for a certain time period in exchange for receiving specific upfront cash flow,” Haworth says. A financial advisor can serve as an important guide to help navigate the often-complex details and potential implications of any strategy using option contracts.
4. Explore the potential of exchange funds
In certain situations, an investor can pledge a stock that represents a concentrated holding in their portfolio to an “exchange fund.” This type of fund allows a pool of owners of concentrated positions of various companies to exchange their large, single holding for units in the entire pool’s portfolio.
Exchange funds are a way to diversify holdings without specifically selling the shares of the concentrated position, thereby deferring taxes on the transaction while achieving broader portfolio diversification. “Investors should note that fees for an exchange fund can be high, and liquidity limitations related to exchange funds and contributed stock may influence their suitability,” notes Merz.
5. Create a charitable remainder trust
Moving some of the stock into a charitable remainder trust and naming yourself as the beneficiary may lessen concentration risk while helping fulfill your charitable goals.
“You can get the benefit of immediate charitable deductions and a future income stream from the asset. Ultimately, the asset will go to charity,” Haworth says. But a charitable remainder trust is irrevocable, so it cannot be changed once funded.
6. Gift highly appreciated assets to charity
You can also fulfill charitable intentions and generate potential tax benefits with a direct gift of shares of highly appreciated stock to a qualified non-profit organization.
If you’re looking to shift some assets out of a concentrated position and planning to itemize deductions on your taxes, transferring stock to a charitable organization by December 31 may allow you to claim a tax deduction for the current year.
Another tax benefit is not having to pay long-term capital gains taxes (equal to as much as 20% of the appreciated value of the stock). Nor are you liable for the net investment income tax (NIIT) of 3.8%, which may also apply if you sell a large position. The charitable organization benefits while you manage your tax liability.
In most situations, investors can effectively manage risk in their portfolios by reducing concentrated positions and replacing them with more diversified holdings. However, there may be circumstances where reducing a concentrated position is less advantageous.
This is particularly true if liquidating the asset would create a significant tax liability (though, as listed above, there are more tax-effective diversification strategies). Tax laws allow a step-up in cost basis when highly-appreciated assets are passed on to beneficiaries at the owner’s death. The potential tax savings can be a consideration for some investors.
“Every situation is unique and requires a detailed analysis of many factors,” Merz says. “It’s important to closely monitor your positions and consider all the risks. Concentration risk should not be taken lightly.”
A financial advisor can help you determine how to effectively position assets as part of your short- and long-term financial plan. If your holdings include your own company’s stock, you’ll need to understand potential company restrictions on selling stock or hedging, as well as the tax implications.
Learn about our approach to investment management.
Why is diversification important in investing? Because risk never disappears – even in times of economic growth.
Qualified charitable distributions and gifts of appreciated stocks offer prime opportunities to enhance your giving and potentially take advantage of greater tax savings.