Wealth Advisory Senior Manager, Capital Group Private Client Services
For clients who have either received a large inheritance or worked at the same company for a number of years, there’s a chance that much of their wealth is tied up in a single stock. This, of course, is rewarding when shares of the company are rising, but may expose them to significant risk should the price drop unexpectedly.
There is no single definition of “concentrated stock,” but a broad rule of thumb is that any position making up more than 10% of a portfolio should be reviewed for appropriateness. Not every concentrated position needs to be sold off. Indeed, it may be possible for a client to continue to hold a sizable amount of one stock if their portfolio also has a solid foundation of well-diversified investments to help meet their goals. But in most cases it’s our job to help clients see the value of a well-rounded approach.
It can be difficult to convince clients who have benefited significantly from concentrated stock positions to lighten their positions and broaden their holdings. Aside from the pure monetary gains, clients may have emotional ties to a company at which they or a family member worked. Nevertheless, I have found over the years that stressing a few key points can help clients understand the risks of concentrated positions and make clear why a more diversified approach is generally best.
Single Holdings Add Significant Investment Risk
As you know, company-specific risk can be a far bigger danger over the long term than general market risk because, while the broad market has historically bounced back from declines, many individual stocks have not. Business-specific risk is especially pronounced among smaller companies, but a large number of established blue chips have also been undercut by forces ranging from short-sighted management to shifting market trends to accounting scandals. Among the more prominent casualties: Lehman Brothers, WorldCom, Enron, Washington Mutual and Circuit City.
In fact, only 54% of companies in the Fortune 500 in 2000 are still on the list today. The rest have either gone bankrupt, merged with another company or simply fallen from the ranking. By one estimate, a mere 12% of companies on the Fortune 500 in 1955 were still on the list 59 years later.
A Rising Market Doesn’t Mean Every Stock Moves Higher
Of course, the stock market rises more often than it falls. Over time, the S&P 500 has advanced in 75% of rolling one-year periods since 1926. But it’s easy to overlook that even in years when the market itself is up, not every stock follows suit. In 2015, for example, the S&P 500 had a return of 1.4%, but half the stocks in the index were down on the year. In 2016, the index had a return of nearly 12%, but just about one quarter of stocks fell.
A Rising Tide Doesn’t Lift All Boats
Even in years when the market itself rises, a significant number of individual stocks do not.
Source: Calculated using data from FactSet. Returns reflect the reinvestment of dividends, interest and other earnings for each annual period between January 1, 2005 and December 31, 2016. Stocks in the index with negative returns represent individual holdings in the index with returns less than 0.0% for the annual period.
Importantly, clients need to understand that volatility tends to be higher for individual stocks than for the market as a whole. The average stock in the S&P 500 is twice as volatile as the index itself, and stocks of smaller companies tend to fluctuate even more. Understanding a stock’s volatility is important partly because it can affect the timing of a sale.
One of the biggest concerns clients have about concentrated stock centers on taxes. There’s no doubt that an investor with a low-basis position in a stock held for many years could face a sizable tax bill when selling shares. However, the tax impact must be put into context. The maximum long-term federal capital gains tax rate is currently 20%. Upper income wage earners are subject to an additional 3.8% net investment income tax, although this tax is assessed only on the gain realized, not the entire value. Still, you should measure the total potential 23.8% tax hit against the possibility of a stock losing one quarter or more of its value, which can be a very real possibility in a market sell-off.
Consider Alternatives to Outright Selling
Of course, there are instances when it may not be advisable to liquidate a concentrated position. For example, for clients in poor health or who are advanced in age, it may be more tax-efficient for their heirs to diversify after receiving a step-up in cost basis following the client’s death.
Likewise, you may want to discuss with clients the benefits of donating concentrated stock to charity instead of selling. I’ve found clients are eager to learn about how they may be able to avoid paying any embedded capital gains tax while benefiting from the tax deduction. You may also point out that giving some shares to charity can be done in conjunction with selling their position, thus having the charitable income tax deduction potentially offset taxes from the sale of shares.
You play an important role in stressing to clients the importance of analyzing the range of options available and examining the totality of their finances, including time horizon, risk tolerance, spending needs and financial goals. Each client is different, but I find that walking them through the basic facts explained above helps them to better understand the risks involved in concentrated stock and the great value in deploying those proceeds into a more-diversified portfolio.
About the Author
Michelle Black, CIMA®, CPWA®, is head of wealth advisory for Capital Group. She has more than two decades of experience implementing portfolio construction and advanced planning strategies for high net worth clients, trusts, endowments and foundations to meet an array of sophisticated objectives.
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