Concentrated equity risk: Is it time to break your concentration?

Sometimes the very thing that creates substantial wealth poses its greatest threat.

While owning a significant amount of a successful stock can be incredibly lucrative – especially in a company on the rise – the more you own of a single equity, the more closely your personal financial fate is tied to its performance.

Even if those fates feel favorable at the moment, it’s wise to consider how breaking up a concentrated equity position could benefit your overall wealth.

Concentration risk

Here’s a rule of thumb: If a single stock comprises a substantial portion of a portfolio –10% to 20%, by some guidance – that portfolio is overconcentrated.

People take different paths to a concentrated equity position:

• The sale of a closely held business for shares of a publicly traded company
• Stock and option incentives from your employer
• A large inheritance comprising a significant position in a single security
• Long-term fundamental investing

But no matter the path, the result is the same: risk.

Beyond fundamental risk, or how underperformance could affect stock price, concentration risk encompasses the potential impact of the total exposure you have to a company’s performance. For those whose concentration is in an employer’s stock, this risk may include shares granted directly as compensation, company shares in an employee retirement account, or company-subsidized health insurance and other benefits.

It’s the sum total of these factors that could make a minor dip in stock price feel like a stomach drop.

Concentration assessment

To explore your potential concentration risk, start with some key questions:

• Imagine you have the cash equivalent of your current shares in a concentrated position – would you invest the entire amount in the stock again?
• What impact would a significant drop in stock price have on your current and future lifestyle?
• How would the reduction or elimination of the current dividends paid by the company affect your cash flow?
• How fully do you understand the myriad factors driving the company’s stock price? How many of those factors do you have influence over? How many are out of your control?
• How would stock price declines or stagnation affect your ability to hit your long-term financial goals?

If any of your answers left you feeling uncertain or generated more questions, it’s time to consider strategies for potentially minimizing the impacts of a concentrated position.

Concentration management

Managing concentrated equity isn’t always, or only, a matter of liquidation. There are multiple strategies that can help you preserve the benefits of ownership in a company’s success while seeking to protect against potential downside risk.

However, as you explore the strategies below, note that the considerations are different if you are an executive or board member with control stock. While serving as a corporate leader, you are an insider and subject to specific regulations and company policies that govern when and how you may transact company shares – and some of these strategies may be prohibited altogether. There are also specific reporting requirements, so it’s important to account for the potential impact of public disclosure as well.

Hedging

The most common techniques for attempting to reduce the downside risk of a concentrated position involve options contracts. These can include protective puts, collar strategies and more.

Monetization

If you’re interested in a cash infusion alongside risk mitigation, monetization strategies include outright sales and margin lending.

Income enhancement

Options strategies may also offer the ability to generate income from a concentrated position. The primary technique for this, covered call writing, allows you to collect an option premium while agreeing to sell your stock at a specified price.

You could also pursue a protective collar strategy, integrating both covered call writing and protective puts, which could provide downside protection against declining stock prices, though it caps the potential for upside gains. There are unique risks to consider when pursuing these approaches, and options strategies are not suitable for all investors.

A covered call writer may be required to sell stock at a specific price, limiting the upside price appreciation of the stock. A put purchaser will protect the value of the concentrated stock position if the stock price declines, but risks losing the entire premium cost of the contract if the price appreciates. A protective collar strategy seeks to balance risk and reward, but it’s important to understand its benefits and limitations.

Tax-efficient diversification

If managing taxes is a priority as you seek to diversify away from a position, you can explore techniques that employ completion portfolios and equity exchange funds.

Planned giving

Getting charitable with your stock through vehicles like trusts, annuities, donor advised funds or outright gifts can help reduce your risk and fulfill your philanthropic goals.

For many of these approaches, saying – or strategizing – is easier than doing. Barriers to overcoming concentration exist in the form of:

• Legal, contractual and corporate requirements affecting the sale of restricted or control stock
• Tax impacts related to capital gains and charitable giving
• Emotional attachment, often driven by professional loyalty and behavioral biases like overconfidence, mental accounting and price anchoring

Whatever your concentration and however interested you are in breaking it at the moment, it’s a critical factor for investors to keep in mind – and to discuss with their professional advisors – as they continue working to achieve their financial goals.

This article is general in nature and is not a recommendation. Asset allocation and diversification do not guarantee a profit nor protect against loss. A Margin account may not be suitable for all investors. Borrowing on Margin and using securities as collateral may involve a high degree of risk including unintended tax consequences and the possible need to sell your holdings, which may lead to a significant impact on long-term investment goals. A copy of the options disclosure document, which contains further information on options, is available from your financial advisor. It should be read carefully before transacting options. Raymond James does not provide tax or legal advice. Please discuss these matters with the appropriate professional. Supporting documentation regarding options strategies will be supplied upon request.