Investors can wind up with a concentrated stock position in different ways. But it's most often from an inheritance, founder, or employee with company stock. Or a long-term investor bought shares years ago, the stock did well, and the investor simply never took profits. But because stocks don't only go up, it's important to have proper risk mitigation and diversification strategies once a concentrated stock holding is identified. Here are four ways to manage a concentrated stock position.
A deep discussion of these strategies is outside the scope of this overview, and because every situation is so different, be sure to discuss your situation with your tax and financial advisor.
1. Different ways to trade
There are more ways to sell stock than just placing one big market order. The main benefit of selling a portion of your concentrated stock is eliminating the downside risk on those shares by locking in gains. Some ways to sell a concentrated holding include: limit orders and stop orders and dollar-cost averaging out of the stock at pre-determined intervals using market orders. The various types of limit and stop orders can help automate the process by only triggering an order to sell if a price gets above or below a specific threshold. Though these can be great tools, it isn't a bulletproof strategy as there's no way to guarantee the order will be filled.
2. Using options to diversify
In some cases, investors can use various options strategies to diversify, reduce the risk of, and/or generate income from a large concentration in one stock. It's important to note that there isn't an options market for every stock. Stocks with a smaller market cap or newly public companies might not have a market. Further, an options strategy is an advanced trading mechanism that isn't appropriate for every investor, so discuss your situation with an investment advisor. And since every option has a term, it's usually most effective as a short-term solution versus long-term strategy.
Here are a few simple examples depending on the goal(s).
Cashless collar: cap downside risk in a cost-neutral way
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With a cashless collar, an investor could sell a call option on a stock they own and simultaneously buy a put option with the proceeds. By selling a call option, you’ll give someone the right to buy the stock from you at a specific (higher) price until a specific date. When you buy a put option, you’re buying the right to sell someone the stock at a specific (lower) price until a specific date. By using both of these strategies together, you essentially set a ceiling for the stock, as well as a floor.
As with anything, there are pros, cons, and limitations to this. For one, the pricing may not be cash neutral, especially if trying to limit your downside and preserve more upside.
Sell a call option: earn income from your concentrated position and potentially sell for a higher price
Instead of using both legs of the cashless collar, this approach just earns income by selling a call option. The premium from selling the option can be used to buy diversified investments. Again, and as with any investment, this strategy has risks and drawbacks, most notably the total lack of downside protection. Options are priced on volatility and the premiums aren't always worth it.
Buy a put option: downside protection on some of your stock
In this example, an investor would forgo the income-generating call option and only buy a put to reduce their risk. This approach could be attractive to investors who aren't looking to sell but want some price protection on a portion of their shares. But there are drawbacks. First, this won’t help diversify the concentrated holding. Further, it means selling other diversified assets (or using cash) to fund the put option purchase, essentially furthering the concentration in the stock. Ultimately, weigh the merits of paying money to sell the stock for less than you could today, if you could just sell it today instead.
3. Harvesting losses from other investments to offset gains
Offsetting gains from a highly appreciated stock sale by harvesting losses from other investments can be a good tax strategy when diversifying a concentrated holding. Essentially, tax-loss harvesting works by selling an investment to realize a loss. Doing so can reduce the net taxable gain from sales of securities with gains. There are tax rules to be aware of, such as wash sales, so consult your tax and financial advisor first.
Tax-loss harvesting isn't always a no-brainer, though. It can create unnecessary turnover in a portfolio and large gaps between the current and target asset mix. Always consider your entire situation and goals, not just taxes.
Before harvesting losses, assess whether you qualify for preferential tax treatment
In most cases, the primary hurdle in diversifying a single holding is the tax implications. Founders and early investors often have super low basis stock to the point where virtually the entire gain is taxable. Taxes should always be a component of any investment decision — but not the main driver.
Individuals who inherit a concentrated stock position should speak with their estate planning attorney to confirm whether they'll receive a step-up in basis. If so, there might not be any material tax impact from selling shares. For company founders and early employees, another consideration is whether the stock qualifies for Section 1202 and can potentially be sold tax-free.
With so many nuances in the tax system, always consult your tax and financial advisor before taking action. For example, individuals considering moving to a low or no tax state before realizing capital gains must ensure those gains won't still be sourced (and taxable) to their former home state.
4. Managing around a concentrated holding
When considering ways to manage a concentrated stock position, the best approach is typically to employ several strategies at once. Although this strategy doesn't reduce the overweight stock, without considering how to manage around it, investors might inadvertently increase their exposure.
To illustrate, consider the following simple hypothetical example:
Imagine your portfolio holds: 20% Microsoft stock, 40% a S&P 500 fund, and 40% in bond funds. In February 2024, Microsoft is the largest company by market cap in the world with a 7.3% weighting in the S&P 500. After considering the overlap of all holdings in your portfolio, the exposure to Microsoft is closer to 23%. In contrast, if 40% of the portfolio was in the equal weight S&P 500 index instead, the underlying exposure to Microsoft would be mostly unchanged (20.08%).¹
Obviously, there's a lot more to consider when making an investment decision than this singular component, and neither of these hypothetical portfolios constitute any real or recommended investment strategy. But it illustrates the importance of looking under the hood of any potential investment to identify holding overlaps between ETFs, mutual funds, and direct ownership of individual stocks in a portfolio.
Final word on ways to manage a concentrated stock position
The situational nature of planning to diversify one large stock position cannot be over-emphasized. For simplicity, this article has only focused on situations where the holding was fully unrestricted. Executives and insiders will typically have different (albeit fewer) options available to reduce risk on shares of their current company. Regardless of the situation, it's important to remember two key things: stocks don't only go up and taxes alone shouldn't drive the decision.
