We’ve all been told not to put all of our eggs in one basket, but there are some investors who think that phrase doesn’t apply to them.
Ever known someone who acted on a hot stock tip only to find out it wasn’t so hot? There are otherwise very smart people who let their exposure to a single stock grow out of proportion to the rest of their portfolio over time, and that can be a recipe for investment disaster.
Concentrated holdings in one stock often occur when an investor accumulates stock in the publicly held company for which he or she works. These holdings accumulate from stock options, restricted stock units or participation in an employee stock purchase plan, or by purchasing company stock inside a 401(k) or deferred compensation plan.
While accumulating, the investor may develop overconfidence bias – the feeling that they have a knowledge advantage because they work for the company. Often, this is not the case.
Few financial planners recommend that one stock comprise more than 5-10 percent of a client’s overall portfolio. All one has to do is remember stocks such as Enron, WorldCom or AIG to know that over-concentration can lead to financial ruin.
Another reason single-stock concentration occurs is through inheritance. If a beloved family member dies and bequests a single stock they’ve held for decades, it’s often hard for the beneficiary to emotionally let go of the stock because they feel they are betraying their benefactor. Guilt is hardly a good investment strategy, but it can drive poor investor behavior.
A final common reason investors don’t let go of a stock they’ve been hoarding for decades is taxes. If that favorite stock has appreciated a great degree over time, selling some or all of the position will trigger unwanted capital gains taxes, which can be as high as 20 percent for those in the top tax bracket. Such a spike in taxable income can trigger other problems, such as higher Medicare rates in subsequent years.
So while it’s fairly easy to justify how a concentrated stock position came to be, there is little financial planning logic that supports keeping it that way – especially if that stock is part of a portfolio to be used in an overall retirement income plan. Concentrated stock positions subject a good retirement plan to unnecessary risk, which, if realized, could force an individual to work longer, have to go back to work, live on less income in retirement or other unpleasant trade-offs.
There are several strategies available to manage the risk and the potential taxes from reducing a large single-stock position in a portfolio. Simple strategies include spreading sales of stock over several years or selling other stocks carrying a loss position so as not to experience the tax bite all at once.
Another frequently used strategy involves using appreciated stock to meet charitable giving goals, by donating stock to a charity or donor-advised fund. Other, more complex strategies exist as well, which can be part of a more sophisticated tax, income and legacy plan.
If your favorite stock is more than 10 percent of your total portfolio, it may be time to start working with a good financial planner to come up with a strategy that’s right for you to reduce this concentration risk over time.