Investors sometimes end up with concentrated stock positions, or too much of one stock in their portfolio, which can be risky. Even though this stock may have the potential for high returns, it can also result in significant losses for the investor. It is essential to be aware of the dangers and learn how to minimize them to manage the risk effectively.
What is a “Concentrated Stock” position?
Although there is no universal agreement on one definition, The Welch Group defines a concentrated position as holding one stock that makes up greater than 7% of the overall portfolio. Individual stocks tend to become concentrated in one of three ways:
- Voluntarily: investors make speculative bets looking for high returns
- Involuntarily: a stock price rises over an extended period
- Employment/executive compensation programs: such programs sometimes offer large amounts of company stock as a means of incentivizing employees and retaining talent
Why are they so dangerous?
When a portfolio has a high concentration of a single stock, it can be risky because the overall portfolio’s success or failure depends on one investment instead of multiple. The saying “Don’t put all your eggs in one basket” is highly applicable here. Although concentrated positions may offer great potential for high returns, the potential downside risk may be devastating. This can be especially true for investors such as pre-retirees, retirees, and others with shorter investment horizons. Many investors refrain from diversification due to tax implications and the difficulty of letting go of a “winning” stock. However, overcoming these mindsets can help prevent significant losses and possibly improve financial security.
Some ways to mitigate the risks of concentrated positions:
- Implement a disciplined portfolio management strategy including:
- Maintaining stocks in multiple companies spread amongst many sectors of the economy (If implementing an individual stock strategy, try to use a large number of companies, 20-30.)
- Rebalance at least annually to keep stock positions below the 7% threshold (Note: While taxes must be considered when rebalancing/selling your winners, see #2 and #3 below for ways to mitigate taxes.)
- Use appreciated stock positions to fulfill a charitable intent and receive a tax benefit.
- By gifting shares of appreciated stock from taxable investment accounts, you can avoid any capital gains taxes associated with a sale and potentially receive a tax benefit in the form of a charitable deduction. See your financial/tax advisor before executing!
- Perform a tax loss harvesting strategy (This involves turning unrealized losses on other stock positions into realized losses, which can offset a portion of the tax hit incurred by realizing gains on the concentrated stock position.
Keep in mind there are alternative methods to reduce the risks linked to concentrated positions, such as hedging strategies. However, regardless of the strategy, it’s essential to consult a financial advisor before implementing any plan since every investor’s situation is different.
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Marshall Clay CFP, J.D., is a Partner and Senior Advisor at The Welch Group, LLC, specializing in providing Fee-Only investment management and financial advice to families throughout the United States. Marshall is a graduate of the United States Military Academy in West Point, New York, the Cumberland School of Law in Birmingham, Alabama, and is a CERTIFIED FINANCIAL PLANNER™. In addition, Marshall is a frequent guest on local television stations as an expert on various financial planning matters.
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