Fork in the Road | Managing Concentrated Stock from Wealth Creation to Preservation
One of the most common paths to creating wealth comes from a single concentrated stock holding. Perhaps the person was an executive at the company, founded the company, inherited the stock, or simply bought and held for a long time. The stock may have helped the individual reach financial independence. After achieving this coveted milestone, people may begin to consider protecting a portion.
And for good reason. While US equity markets have historically appreciated in value over time, and while past performance is no guarantee of future performance, the story for any single company can be quite different. BlackRock performed a study and found from 1987-2023, 66% of stocks in the Russell 3000 Index underperformed the benchmark, including 39% that actually lost money. In the same study, BlackRock found 42% of individual stocks experienced a 50% drawdown AND never recovered the original high price. (BlackRock: Boom or Bust? Managing Expectations for Concentrated Positions and Risk August 2022)
The path to wealth preservation may look different from the path that originally created wealth. We believe concentrated stocks are a classic example of a fork in the road from wealth creation to wealth preservation.
Questions First
The only hard rule about what to do with a concentrated stock holding is this: there is no universal rule for how to manage a concentrated stock. James Clear, author of the bestselling book Atomic Habits said, “The beginner chases the right answers. The master chases the right questions.” Every situation is unique to each investor’s history, goals, underlying holding, and tax circumstances. This is why we start with questions, not answers. Here are some common questions we ask when encountering a concentrated holding:
Is there any personal sentiment or history attached to the holding that should be factored into the decision-making process?
How does the investor feel about the prospects of the company today and in the future?
How does the holding fit within the person’s financial goals?
Is liquidity needed from the holding now or in the near future?
What are the tax implications of selling the position?
Are there any restrictions such as blackout windows, insider restrictions, lock-ups, etc. to consider?
Solutions Second
Here are some of the more common strategies we use to help manage a concentrated stock position. For each one of these options, the investor must consider the (1) exit price of the stock (2) cost and fees (3) tax impact (4) liquidity needs (5) risk willing to bear and (6) how to reallocate the proceeds.
Sell the Stock: Outright sell and diversify the concentrated stock into multiple stocks, new asset classes, or personally use the proceeds.
Covered Calls: Receive premium income on the stock in exchange for being willing to sell a set number of shares at a set price in the future.
Protective Puts: Purchase a put option to hedge against potential losses in the concentrated position. This helps provide downside protection without immediately selling the stock, leaving room for upside.
Collar Strategy: Combine protective puts with covered calls to create a collar. A collar limits both gains and losses. The investor buys a protective put (to limit downside) and sells a covered call (to cap upside) simultaneously.
Variable Prepaid Forward Contract: Explore prepaid forward contracts to monetize the stock position while deferring taxes. In this arrangement, the investor agrees to sell shares at a future date in exchange for cash upfront, deferring the tax liability until the contract matures.
Exchange Funds: Swap the concentrated stock position for a diversified basket of stocks selected by a professionally managed fund. This defers tax consequences until later while creating diversification, but may come with higher fees and/or less liquidity.
Gifting to Family: Gift shares directly to family members, or to a trust for the recipient’s benefit, as part of a tax-efficient estate plan.
Giving to Charity: If already considering charitable plans, give stock to qualified organizations to reduce the concentration, minimize realizing taxes, plus receive tax deductions for the gift. Stock can be given directly to the charity, or an individual can establish a Private Foundation, Charitable Trust, or Donor Advised Fund to receive the initial gift, then give to charitable causes over time.
Oftentimes, the actual solution is a combination of these strategies, thoughtfully implemented across multiple years, market cycles, tax regimes, and personal goals and objectives. That’s why we believe it is critical to have an objective and experienced third-party partner by your side to navigate these complex decisions from both a technical AND behavioral perspective year after year.
If you or someone you know have questions about the current investing landscape, please contact us today at 615-370-1253.
All investing involves risk, including the possible loss of principal. Nothing contained herein should be construed as individualized advice and is for informational purposes only. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client's investment portfolio. Past performance is no guarantee of future performance.
Andy Michael, CFA
Portfolio Manager
