Many are familiar with the popular term “Don’t put all your eggs in one basket”, but how to properly perform the task financially is often a challenge. Should you invest in all stocks, or all bonds or a combination? Should one keep a certain level of cash or should all of your money be invested. Should it all be at one institution or many? These and a variety of questions can be answered, but it usually depends on your risk tolerance.
A common risk to diversification is an inheritance, or investment in your company’s stock purchase plan. Following, is an article from Raymond James that addresses these scenarios.
Five Strategies to Address Concentrated Equity
Owning too much of a single security can be hazardous to your wealth.
August 19, 2016
The risk involved in owning too much (usually defined as 30% or more) of one stock, what’s known as concentrated equity, is pretty apparent – too many eggs in one basket. What’s trickier is why some investors have such difficulty remedying a situation that can pose a real threat to their long-term financial security.
Concentrated equity can arise in many ways. Investors sometimes inherit large amounts of a single stock. They may have sold their business to a publicly traded company in return for substantial amounts of stock, or accumulated a sizeable position through stock and option incentives from a current or previous employer. In some cases, they’ve become enamored with a specific company and acquired an overly large stake. Whatever the particular case, concentrated equity can become an issue investors know they should address but often ignore. Why? Primarily, it’s because of the enemy between our ears – all the emotions that money generates usually revolve around how the concentrated equity occurred in the first place.
The Psychological Barriers to Diversification For example, let’s say you inherited a large amount of a single stock. While that’s nice, you may also have inherited an emotional attachment to the stock. Grandpa may have left you the reward he received from selling the company he built over a lifetime. Perhaps the stock was in the family for many years and has appreciated significantly. That can lead to what’s called “anchoring” – believing the future will be like the past. But, as the fine print says, “Past performance is no guarantee of future results.” Investors who cashed out after working at a company for many years may believe they understand the business very well and will recognize when it’s time to sell part or all of their substantial position. Slimming down a big holding might mean tax liabilities, or a reduction in dividend income. In other words, rationalizations abound.
In these instances, what’s really at work is fear of regret. Behavioral finance experts say that fear of doing something we might regret is stronger than the satisfaction of doing something profitable. Overconfidence is often a factor – many of us trust ourselves, and for good reason. But in the investing world, that could lead to overweighting a stock we believe has upside potential, while discounting the potential downside. Investors may double-down on a particular security that could throw their asset allocation out of whack and possibly add more risk and volatility. Tax aversion sometimes leads investors to take outsized risks rather than diversify sensibly. Plain old inertia plays a role too. When something has worked – “XYZ has been very good to me” – it’s easy to do nothing.
Strategies to Reduce Concentrated Equity Risk No matter what the cause, it’s wise to take a step back and acknowledge that successful investing requires elevating reason over emotion Although every individual’s situation is different, if you have concentrated equity, there are a number of ways to reduce your risk. Here are some strategies to discuss with your advisor:
- Hedging: Using various types of securities, a comprehensive hedging strategy can enable investors to retain their stock positions while also setting limits on the amount of risk they are willing to accept. Hedging strategies generally will involve paying a fixed premium in return for reducing risk.
- Monetization: Investors who want to tap into some of the cash represented by a sizeable stock holding can do so in several ways without an outright sale. Borrowing against the stock in a margin account is the simplest example, but your advisor can explain other strategies that may be preferable for you.
- Tax-Efficient Diversification: While diversifying away from a concentrated equity situation can reduce overall portfolio risk, there’s often a price to pay in terms of taxes. Structuring a plan to mitigate any associated tax liabilities in advance may make it easier to overcome a lingering aversion to potentially higher taxes.
- Income Enhancement: Investors accustomed to a regular income stream in the form of dividends from a large stock position may be more willing to reduce that position if another income source can be created. There are a number of income enhancement strategies for concentrated equity that can accomplish this goal – your advisor can tell you more.
- Tax-Efficient Gifting: Investors with philanthropic or generational transfer goals may be able to reduce their concentrated equity risk while also furthering their individual legacy and tax minimization objectives. Tax-efficient gifting strategies can be complex, so be sure to consult estate planning and tax professionals before making any moves.
Bottom line? If you have concentrated equity and really want to avoid regrets, talk to your advisor about a personalized diversification strategy.
Asset allocation and diversification do not guarantee a profit nor protect against a 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. An investor can lose more funds than he or she deposited in the account. Market conditions can magnify any potential for loss. If the market turns against the client, he or she may be required to quickly deposit additional securities and/or cash in the account(s) or pay down the loan to avoid liquidation. The securities in the Pledged Account(s) may be sold to meet the Margin Call, and the firm can sell the client’s securities without contacting them. An investor is not entitled to choose which securities or other assets in his or her account are liquidated or sold to meet a margin call. The firm can increase its maintenance margin requirements at any time and is not required to provide an investor advance written notice. An investor is not entitled to an extension of time on a margin call. Increased interest rates could also affect LIBOR rates that apply to your Margin account causing the cost of the credit line to increase significantly. The interest rates charged are determined by the amount borrowed. Please visit sec. gov/investor/pubs/margin.htm for additional information.
Raymond James Financial Services, Inc., member FINRA/SIPC
Investment advisory services offered through Raymond James Financial Services Advisors, Inc.
Any opinions are those of Scott Smith and not necessarily those of RJFS or Raymond James.