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The Bay Area is a hub for many industries, including tech, and investors here often find themselves with a concentrated portfolio due to restricted stock grants and incentive stock options. If this describes you, take note: Diversifying your investments can be a smart move.
In our blog, “Time to Part with Your Company Stock? It Depends”, Alex Katz discussed some points of resistance you might face when it comes to unbundling your stock holdings, due to factors like emotional attachment, personal risk profile, or your own assessment of the stock’s value. Kurt Hoefer further investigated the psychology behind risk-averse individuals maintaining risky stock concentrations. Both pieces share some specific strategies for diversifying your portfolio. In this post, we’ll cover the benefits and consequences of unbundling a concentrated position.
As a general rule, you should diversify your portfolio in order to avoid investing too much of it into a single stock. If one company comprises over 20% or 25% of your total investments, then you might be over-concentrated in that position. More conservative sources recommend putting no more than 10% of your holdings in any single stock.
The Bay Area has historically been home to many companies that offer stock incentives to high-level executives. If you’re a leader in one of those companies, you may hold far too high of a percentage of wealth in your employer or previous employer’s stock.
In order to determine whether you’re over that threshold, compare the value of your concentrated holding to the combined value of other holdings in stocks, mutual funds, 401(k) accounts or any other retirement assets, investment real estate, cryptocurrency, money market accounts, and bonds. Exclude personal property like automobiles, boats, or equity in your home.
A concentrated position is risky because your assets are more correlated and thus susceptible to a downturn in the market, industry, sector, or company.
Having a large percentage of your holdings in a single company can help you build wealth quickly when that company is on the rise. However, that same volatility can wipe you out if something goes wrong.
Ask yourself what the impact would be on your finances if something unexpected happened to the company that is your primary holding. If that company is also the source of your salary and your pension, you could be putting your family in a very dangerous financial position.
Even a strong company can succumb to the volatility of a free market. Volatility can arise from a wide range of events outside of the control of management, be they regulatory, macro-economic, death or illness of a key executive, emerging competitive technologies, or simply changes in investor sentiment. The pandemic has been an eye-opener in terms of recognizing how events outside anyone’s control can blindside entire industries and send markets into convulsions.
That’s why most advisors recommend you mitigate your risks by diversifying across different sectors and industries and even consider alternative investments, such as real estate, bonds, precious metals, or international stocks.
One of the barriers to diversifying your portfolio may be the tax implication of locking in any unrealized capital gains. However, there are strategies to help you minimize your tax ramifications.
Each situation is different, and no single strategy works for every investor. Your financial advisor will look at all aspects of your situation to help you manage the tax consequences of your sale. For example, they’ll look at how long you’ve held the stock, how much the gain is, the extent to which offsetting capital losses may exist in your portfolio and any other tax events on your horizon, like having a baby or selling a house.
Your advisor might suggest selling off your stock slowly over a period of years or timing the sale in a particular tax period. You may opt to gift some of your stock to family to move the asset to an individual in a lower tax bracket, or to a charity to avoid recognizing a capital gain while earning a charitable deduction.
One interesting possibility is an exchange fund, where your shares are pooled with shares of a diverse set of companies contributed by other investors in the fund. You would maintain your tax basis but apply it to your pro-rata interest in the diversified portfolio. This solves the concentration dilemma while deferring capital gain taxes.
When to sell off your concentrated stock position is a question that many Bay Area executives must face at some point. It’s a complex issue that involves taxes, financial opportunities, and other aspects of your family’s financial life.
You and your advisor will want to consider several factors, including:
Here in the Bay Area, stock-based compensation is the norm for high-income individuals. Most of our clients are facing the same questions about diversifying their concentrated stock positions, but each client’s situation is unique and requires a custom-tailored approach.
We’re happy to talk with you about the specifics of your situation and help you minimize tax implications while developing a strong, diverse portfolio that will provide a sure financial foundation for your family. Contact us for a consultation to discuss the best strategy for you.
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Advisor Group Manager