I’ve been advising StratiFi on its risk assessment and risk management software offering in large part because it encompasses stock concentration in its risk metrics. Over many years I’ve advised hundreds of clients and have spoken to thousands – in client and professional audiences – on the topic of managing stock concentration. I’ve also written extensively on the topic (Managing Concentrated Stock Wealth: An Adviser’s Guide to Building Customized Solutions).
I urge investors and their advisors to evaluate stock concentration in the full context of the investor’s overall wealth and long-range financial objectives. For some, concentration can be a pathway to success, a deliberate strategy for exceptional returns; or, for many, it can be an unaffordable risk, a problem to be solved. Simplistic, “one size fits all” approaches are rarely appropriate and some combination of tactics is often the best response. As I count them, there are at least 20 distinct concentration management strategies, ranging from immediate and very simple to long-range and quite complex. The complex strategies are often the favorites of those with something to sell or to manage for a fee; the simplest and fastest strategies are, for many, the best way to go.
Context, Constraints, and the Spectrum of Complexity.
There are no reliable “rules of thumb” about concentration. Is a million dollars in one stock a concentration problem? If that investor has only that $1million, almost certainly yes; but if that investor has a portfolio of many millions, perhaps not. Is a concentrated position comprising 25% of a portfolio a problem? Well, if the other 75% is determined to be more than enough to comfortably fund the investor’s key financial objectives, that concentrated 25% could be an affordable bet. If it succeeds, wonderful; but even if it completely fails, it’s not the end of the world…and rarely does any investment completely fail. So, what is “concentrated” is both situational and, at least to some extent, “in the eye of the beholder”.
Concentration is also often a function of individual or institutional constraints. Some investors are very influenced by belief in their superior personal expertise or are limited in their actions by behavioral characteristics of anchoring to a particular legacy price point or over-familiarity with a particular stock because of employment relationships or a founder’s deep identity connection – particularly true in the private company sphere. But, even where there is a will to diversify, some investors are constrained by the specific terms of gifts or trusts, corporate executives face strict securities law limitations on their freedom of action and are very often subject to direct company-imposed requirements to hold certain large amounts for often long periods of time. And private or pre-IPO companies present significant structural limitations on sales or financings to provide liquidity. Very often, there is no market and/or no one willing to lend against the shares.
Still, some investors, with no particular barriers to overcome and with eyes wide open, decide to engage in concentration as a deliberate strategy for opportunistic wealth creation. But even there, strategies for managing the acknowledged risk are often wise. Using the concentrated position as collateral for margin borrowing (that is used to invest in diversified assets) can be a smart move. Limit orders to sell and/or using derivatives (puts and collars) to limit the extent of the possible downside risks are often very helpful. Selling covered calls against the position can produce some “free” liquidity while awaiting a more opportune time to liquidate the core position.
For those who don’t want to accept the concentration risks and are free to diversify, often the best strategy is simply to sell. The ease of this straightforward approach sometimes raises skepticism. “Can it really be that simple?” Sales of publicly traded stock with high transaction volumes are easily executed, virtually instantaneously, and at very low transactional cost. “But, what about taxes?” Yes, taxes need to be taken into account, but, at today’s rates, and even with zero income tax basis in the stock, the worst that happens is a 23.8% federal tax, leaving more than 76% of the value-free to do other things with. With any sizable basis, the tax bill shrinks…maybe to the point where it’s very easy to dismiss as an unimportant constraint.
And if taxes loom large as an impediment to sale, maybe a gift to other, lower bracket family members will do the trick. Maybe even better, if the investor has a philanthropic bent, gifts of low-basis stock to charity are very effective ways to produce tax savings from the deduction, avoid tax on the gain, and do good all at the same time. These gifts to family and/or charity don’t create net new, diversifiable wealth, but they can significantly reduce the overall risk of the investor’s portfolio and achieve important personal goals at the same time.
Integration into the Investor’s Financial Plan.
So, managing concentration, either as an investment opportunity to be cultivated or as a risk to be reduced, is not a thing apart. It’s an essential component of the overall strategy for achieving the investor’s objectives. Advisors would do well to recognize their ability to facilitate the investor’s necessary or desired results on this issue. A tool like StratiFi can play an important part.