Highly Concentrated Stock Positions Are Not a Good Thing

An individual stock is subject to two forms of risk: company-specific risk and overall market risk. Company-specific risk refers to the risk that applies to only a specific company, its industry and sector.

Market risk can be defined as “the riskiness of a stock compared with that of its benchmark. Stocks with less market risk have tended to outperform over time.”¹ While we can diversify away company-specific risk, all stocks are subject to market risk.

As “Diversification Drives Higher Returns” notes, “Since we cannot predict the market’s future, investing in a single company creates a lot of risk. The company could be one that goes bankrupt (for example, from 2005 to 2015, there were 303 bankruptcies of public companies or about 1% of all companies per year¹), or they could be an Amazon or Facebook, which would have delivered holders incredible returns over the past 10–15 years.”²

We diversify because it is impossible to know ahead of time whether a stock will outperform, go bankrupt or end up in the middle.

Diversification is important in an individual portfolio for two reasons:

• First, we know that, on average, individual stocks have underperformed the broader indices
• Second, individual stocks have more volatility than owning a wide basket of stocks

Let’s take a deeper look at real world returns of individual stocks versus the broader market. A quick definition. The median stock return is the middle stock if we rank all stocks from best performing to worst performing. If we picked a stock at random, half the time we would expect a worse return and half the time we’d expect a better return.

We again consider the findings outlined in “Diversification Drives Higher Returns” through “data for U.S. stocks from 1927–2017 using the CRSP U.S. stock database. The average yearly U.S. market return over that time period (91 years) was 12.01%. The median stock return was 8.30% on average. This means that investing in the overall index versus randomly picking a single stock would have earned on average 3.71% more per year. In any given year, there are a few big winners … Going back to 1980–2014, we know that roughly 2/3 of the universe of single stocks underperformed the Russell 3000. The median stock underperformed the index by –54%.”³

Source: Michael Cembalest, “The Agony & the Ecstasy: The Risks and Rewards of a Concentrated Stock Position.” Eye on the Market (Special Edition), J.P. Morgan, 2014.

Diversification also reduces volatility, or the large swings that can occur in the value of your portfolio. According to “Diversification Drives Higher Returns,” “The average U.S. stock has a standard deviation of about 35%. This means that if a stock has an expected return of 7%, the yearly return will be between –28% (7%–35%) and +42% (7%+35%) about two out of every three years. However, if a portfolio is diversified across all 3,000+ stocks that make up the U.S. market, now the standard deviation is below 20%. This means that assuming the same 7% expected return, the yearly outcomes about two out of three times will be between –13% and +27%.” The takeaway here is that this is a much smaller band than that of an individual stock.⁴

This is important when you are planning for something like retirement, which is years into the future and involves decades of spending. When there is less volatility around your stock returns, you should have a better idea of how much to save and spend.

The paper continues with a further discussion of volatility: “In addition, the diversified portfolio has an advantage in growth of wealth because of “volatility drag” on portfolios that cause geometric or compounded returns (average returns in dollar terms) to be lower than arithmetic returns the more volatile a portfolio. The simple logic is that if a portfolio falls by 20%, then it must increase in value by 25% to get back to even.”⁵ This means that with a higher standard deviation, a single company has more ground to make up during down years than a well-diversified portfolio with a lower standard deviation.

Let’s return to “Diversification Drives Higher Returns” for an example comparing $100 invested in two portfolios.

• Single-Stock Portfolio: 7% expected arithmetic return, 35% standard deviation
• S. Market Portfolio: 7% expected arithmetic return, 20% standard deviation

The paper concludes: “Reduction of volatility has a dramatic impact on the growth of wealth, and this is the tangible benefit of diversification.”⁶ As you can see, there are many benefits to reducing single stock or company specific risk and switching to a diversified portfolio.

Now that we know why diversification is so important, let’s look at some ways we can reduce our concentration in an individual stock.

Many investors will consider the following option: “Sell the stock or a portion of the stock outright.”⁷ While the obvious benefit of this strategy is that you immediately reduce your concentrated stock position.

However, a key consideration is the potential tax liability in the form of long-term capital gains taxes and state taxes that can come with selling stock you have held for at least one year. If options have just vested, or you are receiving compensation in the form of RSUs, short-term capital gains on the sale of shares held for less than one year would be taxed as ordinary income. This could be as high as 37% at the federal level depending on your income tax bracket.

One way to address potentially significant tax liability is to sell the concentrated stock position over a scheduled period, which could be over several years.

There are situations where you could accelerate the schedule to sell the concentrated position. It is important to speak with your financial advisor to discuss whether this approach makes sense for you.

A put option is another way to hedge a concentrated stock position. We recommend speaking with your financial advisors to learn more about hedging strategies using option contracts.

Donating stock to charity can be a straightforward way to give to the organizations you are passionate about. Fidelity describes it this way: “When you donate stock to charity, you’ll generally take a tax deduction for the full fair market value. And because you are donating stock, your contribution and tax deduction may instantly increase over 20%.”⁸

For investors who would like their stock to provide charitable giving over the long term, they can consider donating stock into a donor-advised fund (DAF). Fidelity outlines some of the benefits: “The tax deduction for giving their stock to the private foundation would be limited to 20 percent of their adjusted gross income, while for a public charity with a donor-advised program, the deduction limit was 30 percent — a significant difference.”⁹

Lastly, charitable trusts can also be set up and funded with concentrated stock positions. Charitable trusts have many complexities, and we would recommend speaking to an advisor if this strategy is of interest to you.

One of several strategies for handling highly concentrated stock positions is to gift shares to children via trust or gift. For 2021, “the annual gift exclusion limit remains at $15,000 per individual, which is the amount you can gift without reducing your estate exemption.”¹⁰

The potential tax implications of reducing a highly concentrated stock position can seem daunting but there are strategies out there to reduce the risks of single stock ownership. To explore the strategy that makes the most sense for you, please contact your financial advisor.