One of the issues in investing, like in life, is that you can have too much of a good thing. Excessive exposure to one particular public or private company commonly occurs among investors. Single stock concentration may result from inheritance, employment in a large corporation or a successful investment opportunity. Many times, there is an emotional attachment to the position in addition to potentially high tax consequences. In each of these cases, chances are the investment enjoyed positive and robust absolute performance for many years, accompanied by high volatility (risk) that might have gone unnoticed given the strong performance. Investors should be aware of the dangers that exist from maintaining a highly concentrated position regardless of past performance.
When an investor’s portfolio is highly dependent on the movement of one particular position, the risk/return profile of the portfolio may be negatively impacted. A recent study measured performance for stocks in the Russell 3000 from the time they went public to the last reported price. The study indicated that 66% of stocks underperformed the Russell 3000 Index1. While each individual’s situation is unique, there are a number of alternatives to reduce the risk in your investment portfolio attributed to a concentrated position.
Selling. Divesting the position is the most straightforward method to diversify or mitigate risk. An individual can sell his or her position in stages or in large blocks at market price or by identifying a specific price at which to sell. Perhaps the most important consideration about this strategy is the potential tax implication from selling the position. If an investor spreads the sales among a number of years, it may be easier to manage tax consequences.
Hedging. Hedging allows an investor to retain ownership of the position while reducing or eliminating risk. A few hedging strategies are detailed below.
Put Options: Options are an alternative that can provide downside protection to movements in the stock price without having to divest the position. Downside protection is achieved by purchasing puts on the stock. As you might imagine, there is a cost to implementing this transaction however, given that the investor still owns the position, the tax implications from selling the stock are eliminated. In addition, the investor maintains the opportunity to participate if the stock appreciates.
Covered Calls: Selling calls on a stock generates income which helps mitigate a minimum amount of potential downside movement in the stock. The investor maintains ownership of the position if the stock does not reach the pre-established price. If the stock reaches and surpasses the price that was agreed upon, the investor is required to sell the shares. Note that the investor is not protected from significant downside movements.
Collars: This strategy is achieved by purchasing put options and selling call options on the stock. A popular collar is one that has zero cost which is attained if the cost of buying the put equals the proceeds received from selling the call. Ultimately, the investor is protected on the downside once the stock price reaches a certain level. In return for the downside protection, the investor also relinquishes the upside if the stock price increases past a pre-established price.
Exchange Fund: An exchange fund entails the investor contributing his or her stock to a diversified fund in exchange for shares of the fund. The investor’s exposure reflects the movement, upside or downside, of the fund.
Prepaid Forwards: Prepaid forwards allow an investor to receive the proceeds of the sale of the concentrated position immediately while deferring the tax implications. A prepaid forward is an agreement to sell the position at a specific future date and at a specific price range. It is similar to borrowing money except the investor pays back the loan by selling the concentrated position to the lender.
Gifting. If you are charitably inclined and have an interest and need in any given year to contribute to a worthy cause, gifting a concentrated position with a low cost basis may be a viable solution that fulfills several purposes. By gifting the position, the overall risk in the investment portfolio is reduced and you are not subject to the tax consequences of selling the stock.
The strategies detailed above represent merely a few strategies available to reduce the risk of a single stock position. If you find yourself with a concentrated position, you probably have profited from accumulating and retaining a large quantity a single stock. Nevertheless, the heightened volatility and risk should be recognized and addressed.
