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Concentrated Stock Positions and the Risk They Pose to Your Financial Health

It's the time of the year when young kids are running around, baskets in hand, in search of those colorful eggs and the sweet treats contained within.  And it presents a moment to recall the ever famous investing wisdom to not place all of them in the same basket.  Today, I'm proposing that we adjust that proverb to read:  Never place most of your eggs in one basket.


What constitutes a concentrated stock position?


There is no perfect or precise answer here, but the most common threshold that I see from within the advisor community is >10% of your investable assets.  Some portfolio software will call out anything greater than 5% as a concentrated position.  To give some perspective, as of this writing Microsoft (MSFT) is the largest public company by market capitalization and it currently makes up 3.83% of the S&P 500.  MSFT could declare bankruptcy tomorrow and your net worth would not be tangibly impacted if you are broadly diversified.  If you are 55 years old and MSFT shares account for 50% of your portfolio, your lifestyle, both now and in retirement, would take a devastating and irreversible hit.  One of the most notable cases of this in recent history is the collapse of Enron in 2001.  You can simply Google "what happened to Enron" and you'll be flooded with stories written from many different angles.  The point of this post isn't to spotlight corporate fraud and failure, it's to illustrate the risk of having a large portion of your portfolio tied to one company, no matter how big or how invincible they appear.  Click HERE for a glimpse into life after Enron for several long-time employees and retirees.

You may ask is it really likely that your company could crash and burn in similar fashion and I would concede that the probability is very low.  But even if your concentrated position doesn't end in bankruptcy and prison terms for the executives, your portfolio still has a very realistic probability of suffering a material decline:

Since 1980, shares of roughly 40% of the companies listed in the Russell 3000 Index, a listing of the 3,000 largest U.S. companies, suffered serious declines of more than 70% from their peak value; moreover, their recovery was minimal. Eventually, this group lost 60% or more from its peak. Technology, telecom energy and consumer discretionary had the highest loss rates. Some subsectors—biotech (part of healthcare) and metals & mining (part of materials)—had loss rates of more than 50%.1

A concentrated position is a big risk, regardless of the company.  It is especially dangerous if that company is your current employer.  You're already relying on them for your salary and your benefits (including health care).  Does it really make sense to add your financial security in retirement to the list?


1 Cembalest, Michael. The Agony & The Ecstasy. Page 4. J.P. Morgan Asset Management, August 2014.


Why do people allow their portfolio to become so concentrated in the first place?


There are many inherent biases that drive this kind of investor behavior.  If we focus on investors that accumulate large blocks of shares in the companies they work for, familiarity bias is the likely cause.  

Familiarity bias is an investor preference for companies that they buy products from, that they work for, or where they have a family connection. Because of familiarity bias, investors may misread past or future market fluctuations thinking that they’re predictable, resulting in overconfidence.2

I'm sure if you asked the Enron employees why they had their entire 401k in company stock, they would say something like "Everyone was doing it" (herd mentality bias) or "the stock was returning way more than the alternatives in the plan" (recency bias).   Aside from these cognitive biases, I think in many cases inertia is the culprit.


2  6 Cognitive Biases in Behavioral Finance. The American College of Financial Services, September 2018.


What do you mean by inertia?


I live in the Bay Area and find myself surrounded by the tech giants that dominate the region.  If you spend a few minutes thinking about the typical compensation structure offered by these companies, it becomes obvious why many people end up with a stockpile of company shares.  A quick example:

Base Salary:                     $175,000

Target Bonus (20%):       $35,000      (Bonus paid 50% in cash and 50% in equity)

RSU grant at hire date:  $75,000    (3 year vesting period)

ESPP (15% discount):      $17,500      (10% of base withheld to purchase shares every 6 months)

In this example, after 1 year at the Company this employee would have accumulated the following in equity (ignoring changes in share price and the ESPP discount impact):

$17,500 (Bonus) + $25,000 (1/3 of RSU grant) + $17,500  (ESPP) = $60,000  (total)

The longer they stay, additional RSU grants will start to stack up until they are vesting closer to the full $75,000 initial grant on an annual basis.  Now imagine this employee has been with the company for 10+ years AND they haven't sold any of their shares AND the share price has appreciated.   The appreciation is a good thing, of course, but the point here is the inertia of the compensation structure combined with inaction by the employee makes for a huge financial risk in their portfolio.


What is wrong with holding shares in my company's stock?  Isn't that part of being loyal and demonstrating that I believe in the company's products or services?


There is clearly nothing wrong with having an ownership interest in the company that you work for.  It provides additional incentives to do productive work and to add value.  That said, you already devote full-time hours (and likely many more), you sacrifice the occasional weekend to deliver on a key project, you take calls while you're on PTO to keep things moving forward.   You are trading a significant amount of your most valuable asset (time) in exchange for the compensation that funds your lifestyle.  Selling your shares and diversifying doesn't make you any less valuable or loyal.  


When asked about this topic, Warren Buffett's response was "Diversification may preserve wealth, but concentration builds wealth".  Isn't he the greatest investor on the planet?


Yes, Mr. Buffett is considered by most to be the greatest investor of his generation.  And from a purely technical or mathematical perspective, it's hard to argue with his position.  If you happened to have the superior analytical skills or simply the dumb luck of finding a relatively unknown company like Google in 2004 and you decided it was prudent to invest substantially all of your available capital in the future search engine behemoth, your account balance in 2019 would be a quantum leap ahead of the guy who opted for a diversified portfolio that tracked the S&P 500. 

But asking Warren Buffet is he prefers to diversify and get market-like returns or to "go big" on a few concentrated positions is like asking the late Dale Earnhardt if he prefers driving a Toyota Camry at 55 MPH or racing the Daytona 500. Buffett has the unique skills, mentorship from the godfather of value investing (Benjamin Graham), access to data and company executives, yada, yada.  Most anyone can see the high risk involved and high skill required to race a stock car at 200 MPH.  I hope that by this point, I have convinced at least a few of you that placing a large portion of your wealth or retirement savings in one company is equally hazardous and should only be undertaken by the very highly skilled such as Mr. Buffett.


What are my options if I want to diversify out of a concentrated stock position?


There are several viable options to reduce or eliminate the risk of having a large portion of your investment assets tied to one company:

The logical first step to address your concentrated position is to stop the inertia mentioned above and prevent more shares from being added to the already large position.  When new shares vest, immediately sell the shares and get the money into diversified holdings.  You might ask "But don't I want to avoid short-term capital gains rate taxes?".  If you sell your shares at the first opportunity, you will be taxed at ordinary income rates and you get the exact same outcome as if the company paid you in salary as opposed to RSU's.  Treat the RSU's like base salary, not like long-term investments.

For the large block of shares that has already accumulated, you have several options to address this risk:

Outright or Staggered Sale:


- The most obvious approach would be to simply sell all vested shares in your brokerage account and use the proceeds to purchase a diversified portfolio.   Depending on the size of your holdings, the cost basis, and your holding period, this may or may not be an optimal choice.   The pros on this approach are the simplicity to execute and the speed in which you can resolve the issue.  The argument against this would be the potentially very large tax liability if your shares had appreciated since they were purchased or granted (in the case of RSU's).

- If the tax bite would be too big to absorb in one year, Plan B could be to set a defined schedule (i.e. sell 25% of the stock position within each of the next 4 tax years).  While this helps the tax situation, this also means that it takes several years to truly diversify away the concentration risk.  You could still suffer significant losses if the shares tank prior to your scheduled liquidation. 

PLEASE NOTE:  Always confirm that it is not a blackout or restricted period (i.e. shortly before your company announces quarterly earnings) before selling any shares and NEVER trade while in possession of any material non-public information.


If neither of these first two strategies works for you and you still want to address the concentration risk in your portfolio, there are additional strategies available, but they generally fall outside of the DIY category:

Options: 


The are multiple strategies that employ the use of options.  Also known as derivatives because the derive their value from the underlying security that they are tied to.

A strategy called a protective put is appealing to the investor who is holding shares which have appreciated in value and she wants to lock in a minimum gain while still holding the shares and their potential for further appreciation.  Think of this like insurance on your shares.

Click HERE for an Investopedia article that walks through the protective put.

Another strategy leveraging options is the protective collar.  This strategy could make sense for an investor that wants to unload their shares but prefer to spread the sales over multiple tax years.  The collar can enable them to hold shares that will be sold at a later date while also keeping the ultimate sale price within a defined range (i.e.  holding shares at $100/share and executing a collar that will unload the shares at a price between $95 and $105 at some point in the future). 

Click HERE for an Investopedia article that walks through the protective collar.

The use of "protective" in each strategy tells you that these are hedging strategies (i.e. reducing volatility risk).  They are not designed or intended to make a profit on the options themselves. 

Before engaging in any transaction involving options, at a minimum you should consult with a financial professional and in many cases you'd be well advised to enlist their help in setting up, executing, and monitoring your preferred options strategy.  In fact, most custodians (i.e. Fidelity, Schwab) will require paperwork covering your trading experience, income, and net worth prior to authorizing your account for options trading. 

Exchange Funds:


Exchange funds allow you to exchange your blocks of securities for shares in a limited liability partnership or limited liability company that invests in a diverse portfolio of securities. Two big qualifiers: (1) exchange funds are extremely illiquid – the typical commitment is seven years, with substantial penalties for withdrawing during the first three to five years of ownership.  (2) Most exchange funds have a minimum investment of $1MM.  This very high entry point and 7 year lock up period make this strategy unavailable for many investors.

So, now that we have a basic understanding of concentrated positions, the biases and compensation structures that create them, the financial risk associated with them, and some strategies to reduce or eliminate them, what's the key takeaway?

Unless you have Warren Buffett's investing skills (and massive bank account), the bottom line on this topic:  Diversification always trumps conviction!

If you find yourself with a concentrated stock position and you're not sure of the best strategy to address it, please contact me to schedule an initial consultation.