There is a reason for the saying “don’t put all your eggs in one basket.” It may have something to do with the risk of owning too much of one stock. According to a recent Goldman Sachs Asset Management study, 23% of the stocks in the Russell 3000 Index (a broad measure of the U.S. stock market) lost more than a fifth of their value in an average calendar year from 1986-2019. The study found the average stock was more than three times as volatile as the Russell 3000 index (Source: FactSet, GSAM).
Volatility is a measure of risk, how much the stock price fluctuates. If a single stock is more than three times as volatile as the index, brace yourself for wild ride. Volatility on the upside is a good thing when the stock goes up. Negative volatility or price decreases - as in case of Boeing which is down 38% in the past year - can lead to steep losses (Source: Morningstar). That is why investment advisors preach diversification. Spreading the risk around different stocks can mitigate the effects any one stock has on the whole portfolio.
Given the research from Goldman Sachs, investors with a large concentration in one stock may be on a wild and risky ride in the years ahead.
Despite the research to the contrary, some investors are overweighted to one stock. When one stock is more than 10% of the portfolio, we call this a concentrated stock position, and a red flag goes up. There may be several reasons for the concentrated stock position. Some can't sell their company stock due to employer restrictions. Others don't want to pay the income tax on the gain. Some think the stock may go higher.
Investors should not underestimate the risk of owning too much of one stock – see Lehman Brothers, Worldcom, Enron, Pier One, Frontier Communications, and Hertz to name a few examples. If you are concerned about the risk one large stock position has on your retirement nest egg, as you should be, here are four solutions to consider:
What to do?
Gifting to Charity
Gifting the stock to a qualified charity is one idea. Donating allows you to get rid of the stock and not incur the tax from selling. Be sure to gift the shares with the lowest cost-basis or the largest taxable gain.
Before you sell the stock, see if you can use losses in other parts of the portfolio to offset the taxable gain. We call this tax-loss harvesting. This can only be done in non-retirement accounts. We manage several portfolios that actively harvest losses throughout the year when they come up. We try to match the harvested losses to the gain incurred from selling the concentrated stock position. This helps reduce the net taxable gain at the end of the year. The smaller the taxable gain, the less tax owed, which is a good thing.
Unused losses are carried forward to future years on the federal tax return. Some states may allow you to carry forward unused losses on your state tax return. Taxpayers can also deduct $3,000 of losses from their Federal taxable income each year.
For more sophisticated investors, an Exchange Fund swaps your stock for a pool of diversified stocks. Since it is a swap, and not a sale, there is no immediate income tax due. The benefit is the pool of stocks provide greater diversification. Exchange Funds are relatively new, available only to Qualified Purchasers (investable assets greater than $5MM) and illiquid - generally a seven-year lock-up.
Investors can also use options to mitigate the downside of a stock's loss. One strategy is a "zero-cost collar." A zero cost-collar involves writing a call option - selling a call - and using the income to buy a put option on the underlying stock. Buying the put option gives you the right to sell the stock at a predetermined price. That comes in handy if the stock price drops. Writing the call provides income to buy the put option, hence the "zero-cost."
It doesn’t always work out to a “zero-cost", but it is usually close. The figure to the right illustrates a collar strategy with Chubb Stock (Symbol CB). Options involve risk, are complicated, and can reduce your upside. It's best to consult with an experienced professional before implementing an options strategy.
The Biggest Risk
The biggest risk, in my opinion, is not having a plan to deal with a concentrated stock position. Letting the years go by without doing anything only complicates the problem. The stock position may get larger and the tax bill higher. In my opinion, a diversified portfolio should not have more than 10% of the assets in any one stock. Luckily, as described above, there are several ways to manage a large stock position in a tax-efficient and smart way. It all starts with a plan.