Concentrated Risk: Too Much of a Good Thing?

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January 15, 2016

Corporate executives know there are many financial benefits that often come with the job, including stock options, profit sharing and other-equity based compensation. These tactics can help build considerable long-term wealth, but they can also expose your investment portfolio to unnecessary risk. Holding too much of a single stock – even if that stock is in your own company – creates an unbalanced portfolio, which means a sudden market shift or business crisis could decimate its value.


“Having a large position of any one stock in your portfolio is risky,” says Robert Haworth, CFA, Vice President and Senior Investment Strategist for U.S. Bank Wealth Management. “No one knows the future.”


“A surprisingly high percentage of even large, blue chip companies frequently experience large stock price declines,” adds Bill Merz, CFA, Vice President of Derivatives and Structured Products for The Private Client Reserve. He notes that having an overly concentrated portfolio can be counterproductive to your investment goals.


A Cambridge Associates report on Concentrated Stock Portfolios shows there’s a 41-50 percent chance that a portfolio consisting of a single stock will fall 25 percent or more in a given five-year period. That’s compared with only a 13 percent probability for a diversified portfolio. “As a fiduciary, it is our duty to help clients reduce that level of uncertainty when appropriate,” Merz says.


How to diversify prudently


Fortunately, Haworth says, there are many investment tools that can help investors mitigate

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the risk of a concentrated stock portfolio slowly and methodically to potentially protect the assets and minimize penalties. “You want to pay attention to how you exit a stock, what the risks are and what you are trying to accomplish,” he says.


  • Mitigate risk with hedging strategies while potentially retaining ownership of your shares. There are a variety of strategies, many of which utilize option contracts that may help to reduce downside risk. The cost of this strategy can come in the form of either paying out of pocket, or in exchange for limiting potential price appreciation over a predetermined amount of time. These strategies may also allow investors to retain the shares, avoiding the large potential capital gains tax liability that may result from selling, although depending on the contract the owner may be forced to sell shares. Keep in mind that options involve substantial risk and are not suitable for all investors1.
  • Liquidate the shares over time. You can increase diversification in your portfolio through the development of a plan to sell shares over time. Covered calls are another effective way to generate incremental income along the way. “Covered calls have the effect of capping potential appreciation for your stock for a certain time period in exchange for receiving specific up-front cash flow,” Haworth says.
  • Create a charitable remainder trust. If you have long-term charitable giving goals, you can move some of the stock into a charitable remainder trust, instead of donating cash, and name yourself as the beneficiary of the trust. This lessens the concentrated risk in your portfolio while potentially creating revenue and tax benefits from the donation, Haworth explains. “You can get the benefit of immediate charitable deductions and a future income stream from the asset, which will ultimately go to charity.”  A charitable remainder trust is irrevocable so it cannot be changed once funded.
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These are just a few of the strategies investors can use to diversify a concentrated portfolio. Before making any decisions, talk to your wealth manager and create a plan. “Every situation is unique and requires a detailed analysis of a number of factors,” Merz says.


That includes understanding any potential company restrictions on selling or hedging activity, the tax treatments related to the stock holdings, and the role these stocks play in your short- and long-term financial planning, he says. “We can help navigate these choices while being mindful of

tax impact, income requirements, gifting and charitable causes and any other family goals.”

 Prior to buying or selling an option, investors must receive a copy of "Characteristics and Risks of Standardized Options." Copies of this document may be obtained from an investment professional, from any exchange on which options are traded, or by contacting The Options Clearing Corporation at One North Wacker Drive, Suite 500, Chicago, IL 60606 (phone: 1-800-678-4667).


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Financial Planning