If one stock represents 20-30% or more of your portfolio, your wealth may be too concentrated and therefore subject to risk from the ups and downs of that security.
This can happen any number of ways: perhaps you inherited a significant stock position, acquired the stock when you sold a company, or worked for the company over many years. The company’s shares may have run up nicely over a long holding period.
Is your concentration dangerously high? Opinions vary as to how much is too much, but any large decline in a concentrated holding could seriously impact the value of your portfolio.
The decision to hold or sell the shares may involve both objective and subjective considerations. For example, some people have an attachment to a stock they inherited from a parent who instructed them not to sell. Now it’s a favorite stock with a low cost basis, which encourages a tendency to continue holding the large position. They want to avoid missing out on price appreciation if they sell. They also want to avoid or defer the tax liability on a big gain.
There are several strategies available designed to reduce risk and meet objectives for creating liquidity, hedging the position, or diversifying.1 You may be trying to achieve more than one of these goals.
Creating Liquidity
Selling the shares outright may be the simplest strategy. But selling usually triggers a taxable event and prevents you from participating in the stock’s future gains and losses. Company insiders may face additional complications, such as selling windows and regulatory restrictions. There are other ways to create liquidity, including writing call options, borrowing against the position, or committing to a variable prepaid forward contract, which is used to capture liquidity and delay the tax implications of an outright sale.
Corporate insiders are subject to SEC restrictions as to when and how to sell. If you are a corporate senior executive, director, or did not receive the stock through a public offering, compliance with the SEC regulations governing the sale make selling a little more complicated. Officers and directors, as well as those who own more than 10% of a stock, must report their holdings and any transactions involving the stock. They may be concerned about public scrutiny of any sale.
Pre-Planned Selling Program for Insiders
Corporate insiders may face selling scrutiny or be prevented from selling during blackout periods or when in possession of material nonpublic information. The Securities & Exchange Commission allows executives to establish pre-planned selling programs under Rule 10b5-1. As long as executives follow the provisions outlined in Rule 10b5-1, they may establish a schedule for pre-planned sales that specify their plans and allow them to execute sales during periods they might not otherwise be allowed.
Hedging
Hedging is a strategy to reduce the risk of adverse price movements. Through the use of options, you can hedge your stock position, either through a protective put, a collar or a prepaid forward contract.
A protective put is an option that protects the value from falling below a predetermined price.
A collar involves the simultaneous sale of a call option and purchase of a put as a means to hedge a long position in the underlying stock.
The prepaid forward contract provides a cash payment to the owner today in exchange for agreeing to sell within a set price range at a future date.
There’s a lot more to learn about these hedging techniques. Even though they sound quite complex, the purpose is simple: investors use hedging to reduce their exposure to various risks. It’s important to take time to learn more about each of these options strategies to understand the risks, costs and potential outcomes.
Diversifying
If paying the taxes is the major impediment to diversifying, take a measured approach. You can follow a strategy to lighten up on the stock position over time to moderate the impact of taxes.
If you have intentions to leave the stock to charities or heirs, there are ways to diversify the risk of concentration. Anyone who plans to bequeath the stock in the near term may leave it to the heir to pay the taxes. At the investor’s death, the beneficiary may benefit from a stepped up basis, and sell the stock with little or no capital gains tax.
For those who have charitable inclinations, gifting stock to a Charitable Remainder Trust (CRT) may be one way to meet your financial planning goals and charitable intentions and get an immediate tax deduction. When you transfer the asset to the CRT, you no longer own the asset, but will benefit from a deduction equal to the value of the stock you have given.
Consider this a preliminary discussion about protecting your assets, particularly if you have a large position in one or two stocks. If you are concerned about having a substantial portion of your wealth tied up in a single stock, it may be time to have a thoughtful discussion with your financial advisor about the pros and cons of creating liquidity, hedging or diversifying your position.
Summary
There is a risk in owning too much of even a high quality company. You need to consider the overall level of concentration, your risk tolerance and investment time horizon, and the tax impact of selling. The risks need to be understood and contrasted with the cost of selling and paying the capital gains taxes. Reducing a concentrated stock position may help you advance your long-term goals. Contact us to learn more.
1. Some of the strategies discussed may not be permitted by company insiders. Check with your corporate counsel to from sources we believe to be reliable, but its accuracy, completeness, or interpretation cannot be guaranteed.
The information contained in this article was developed from sources deemed to be reliable. This is not an investment recommendation or endorsement of any strategy contained herein.
© 2015 LederMark Communications.
