5 Strategies to Address Concentrated Equity - Butler Financial, LTD
Important Tax FAQs


5 Strategies to Address Concentrated Equity

Owning too much of a single security can be hazardous to your wealth.

December 16, 2018

The risk involved in owning too much of one stock – known as having concentrated equity – is pretty apparent: too many eggs in one basket. What’s harder to understand is why some investors have such difficulty remedying a situation that can pose a real threat to their long-term financial security.

Whether from an inheritance, a business sale, or company stock incentives, concentrated equity can happen in a number of ways. In some cases, it even results from simple affinity for a particular company. But whatever the cause, it often becomes a problem that’s tricky for investors to correct on their own. Why? Primarily, it’s because our emotions like to get the better of us.

Psychological Barriers to Diversification

When investors inherit a large amount of a single stock, they sometimes develop an emotional attachment to the securities. For example, you might be more attached to stock that was gifted by a beloved grandparent or that came from the sale of a family business. Perhaps the stock has been in your family for many years and has appreciated significantly.

But just because the stock holds a special significance for you doesn’t mean that it’s necessarily the right fit for your portfolio. Although it can be challenging, it’s important to place emotions to the side and determine whether your holdings are an appropriate reflection of your financial goals, regardless of how you acquired them.

Familiarity and overconfidence can be hurdles to diversification as well. 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. But this can lead to blind spots, causing us to overlook potential downsides and underestimate risk.

Sometimes, overconcentration can result from our fear of loss and regret. We get stuck in our current investments, fearing that we’ll make the wrong move by selling. We might try and rationalize how things currently stand, citing tax consequences or changes to dividend income as reasons to leave things as they are. But while these factors should certainly be considered, they shouldn’t render you frozen in an allocation that doesn’t support your long-term success.

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, talk to your advisor about a personalized diversification strategy that would best support your holistic long-term plan.

Investing involves risk and you may incur a profit or loss regardless of strategy selected. 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.

Other posts you might like
The next level of play in the financial markets

Markets & Investing April 01, 2024 Raymond James CIO Larry Adam reminds investors they need to be well...

read more
March highlighted by markets rising to record highs

Markets & Investing April 01, 2024 Market rally driven by a broadening of the market and optimism that...

read more
No fooling – a silver lining for investors

Markets & Investing April 01, 2024 Doug Drabik discusses fixed income market conditions and offers...

read more