3 steps for managing concentrated risk in your portfolio

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April 02, 2018

If you’re an executive with a heavy concentration of your company’s stock, you may feel so confident in your company’s future that the added risk of holding a concentrated position doesn't bother you. Or, if you’re an investor whose concentrated portfolio has experienced outsized gains relative to the S&P 500, you may be satisfied with your current strategy.  


Did you know, from 2003 to 2013, 92 percent of individual S&P 500 stocks experienced volatility greater than the S&P 500 index as a whole, according to Cambridge Associates. Moreover, 11 percent of those stocks lost more than half their value during that period. In other words, while you may currently be doing well with a concentrated portfolio, the danger of a substantial drop is real. 


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


Even blue chips get the blues


“A surprisingly high percentage of even large blue-chip companies frequently experience large stock price declines,” says Bill Merz, CFA, Vice President and Senior Research Analyst for U.S. Bank. 


According to Cambridge Associates, there’s a 41 to 50 percent chance that a portfolio consisting of a single stock will fall 25 percent or more in a given five-year period, compared with a 13 percent probability for a diversified portfolio.


Fortunately, you can mitigate the risk of a concentrated stock portfolio slowly and methodically. “You want to pay attention to how you exit a stock, what the risks are and what you are trying to accomplish,” Haworth says.


Consider these three ways to reduce the risk in a concentrated portfolio without having to worry about asset risk or tax penalties.


1. Minimize your portfolio risk by hedging your holdings. 


If you want to keep your concentration intact, consider strategies that use option contracts that can help reduce your downside portfolio risk by allowing you to hedge. Also, by holding your concentrated shares, you will avoid the potential capital gains tax liability that may result from selling. 



The cost? You may have to pay out of pocket to buy the options, limit the potential price appreciation of your shares over a predetermined amount of time, or both. Depending on the circumstances, there may also be tax considerations.


2. Slowly liquidate your shares. 


Selling your shares over time will help diversify your portfolio while helping to minimize risk and tax liability. Consider covered calls, which entail selling call options at a strike price higher than the stock is currently trading, are another effective way to generate incremental income along the way. If the stock falls or is flat by the time the call expires, you keep the premium. If the stock rises, you limit your upside. 


“Covered calls have the effect of capping potential appreciation for your stock for a certain time period in exchange for receiving specific upfront cash flow,” Haworth says. 


3. Create a charitable remainder trust.


Moving some of the stock into a charitable remainder trust and naming yourself as the beneficiary will lessen concentrated risk while helping fulfill your charitable goals.


“You can get the benefit of immediate charitable deductions and a future income stream from the asset, which will ultimately go to charity,” Haworth says. But remember: A charitable remainder trust is irrevocable, so it cannot be changed once funded.


These are just a few of the strategies that can help you diversify a concentrated and potentially risky portfolio. Talk with a financial advisor to figure out how to position the concentration as part of your short- and long-term financial planning. Also, remember that if you have your own company’s stock, you’ll need to understand potential company restrictions on selling stock or hedging, and the tax implications.  


“Every situation is unique and requires a detailed analysis of a number of factors,” Merz says.   


Options involve substantial risk and are not suitable for all investors. 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).