If your portfolio is concentrated in a narrow group of stocks, you may add to your investment risk.
A variety of strategies can be considered to help diversify your portfolio or manage the risk of your existing positions.
Talk to a financial professional to help determine 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’re holding stock of the company where you work. 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, CFA, senior vice president and senior investment strategy director at U.S. Bank. “No one knows the future.”
“You want to pay attention to how you exit a stock, what the risks are and what you’re trying to accomplish.”
Rob Haworth, senior vice president and senior investment strategy director at U.S. Bank
“A surprisingly high percentage of large blue-chip companies frequently experience large stock price declines,” says Bill Merz, CFA, senior vice president and senior portfolio strategist at U.S. Bank.
Fortunately, you can mitigate the risk of a concentrated stock portfolio slowly and methodically. “You want to pay attention to how you exit a stock, what the risks are and what you’re trying to accomplish,” Haworth says.
Following are four strategies that may reduce concentration risk in your portfolio, as well as potentially reduce asset risk or tax penalties.
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.
Selling your shares over time will help you gradually diversify your portfolio while helping to minimize risk and tax liability. Consider covered calls, which entail selling call options at a strike price higher than the stock is currently trading. It may be an effective way to generate incremental income along the way. If the stock falls or its price remains flat by the time the call expires, you keep the premium. If the stock rises, your upside is limited.
“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.
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.
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 Dec. 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.
These are just a few of the strategies that can help you diversify a concentrated portfolio and potentially reduce its risk. “Every situation is unique and requires a detailed analysis of a number of factors,” Merz says.
Talk with a financial professional to 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, and 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.