The Hidden Cost ofHolding a Concentrated PositionWhy diversification can help to protect wealthBy Baird’s Advisory Services ResearchExecutive SummaryFamily wealth created by holding a single stock that appreciatessubstantially in value over time is fairly common. For example,senior company executives receive stock or stock options as part oftheir compensation, investors benefit from superior appreciationof one stock relative to the rest of their portfolio, or family membersinherit a large position in a single stock. Regardless of how theconcentrated position is acquired, it results in a disproportionateallocation of wealth, which exposes the family to undue risk thatshould be understood and managed.Whether investors understand the risks of holding a concentratedposition or not, there is a tendency to hold onto these positions.Corporate executives may face insider selling constraints or concernsabout how a sale would affect the market price of their company’sstock. Other investors simply have an emotional attachment to thestock. Many investors are concerned about the tax implicationsof selling.Despite these seemingly valid reasons, there is a critical point formost investors and families where the desire for wealth, incomeand lifestyle preservation outweighs the need for further wealthcreation. This is especially true when investors approach retirementor life events during which they will more heavily rely on theiraccumulated wealth.The goal of this paper is to educate investors about the hidden risksassociated with holding significant wealth in concentrated positions,and to suggest strategies to help mitigate and manage those risks.
The Risk/Reward Implications The results of this study showed Defining Concentrated of a Concentrated Position that over half of the individual Position Investors who have benefited from stocks underperformed our 60/40 A concentrated position occurs holding a concentrated position often diversified portfolio, and that all of when an investor owns shares believe that past performance will the individual stocks showed much of a stock (or other security continue indefinitely, and may find it higher volatility. The average stock’s type) that represent a large difficult to imagine a downside. While volatility was nearly four times that percentage of his or her overall it’s tempting to believe a successful of the diversified portfolio. There is portfolio. The investor’s wealth stock will remain that way, studies no perfect way to know which stocks becomes concentrated in the show that investments in a diversified will be the winners over the long single position. Depending on portfolio will produce greater term, and the cost for being wrong the volatility of the stock, and long-term wealth than investments can be high. For example, the return the size of the client’s portfolio, a of 160 stocks failed to keep pace in a concentrated position, with position is often considered to be with inflation over the period, and significantly less risk. concentrated when it represents 104 of the 272 stocks were down 10% or more of one’s portfolio. In order to better understand the 20% or more in value at the end of risk/reward tradeoff of holding a the decade. concentrated stock position, Baird constructed a hypothetical diversified In fact, the 60/40 diversified portfolio portfolio1 consisting of 60% equities returned 45% cumulatively over the and 40% fixed income and compared decade while the S&P 500 was down it with the 272 individual stocks that 26%. A good example is General remained consistently in the S&P 500 Electric. The chart below compares Index for the 10-year period of March the performance of General Electric’s 31, 1999 to March 31, 2009. stock to the diversified portfolio overConcentrated Equity Position: “What If” Analysis Ten-year Performance: Stock vs. Diversi ed Portfolio Growth of a $100,000 Investment Over the Past 10 Years$200,000 Diversi ed Portfolio$175,000 GE Diversified$150,000 $144,908 Portfolio$125,000 10-year (7.1%) 3.8% Higher$100,000 Annualized Return Return $75,000 10-year 28.3% 10.6% Less GE Annual Volatility Volatility $50,000 $47,657 $25,000 Diversified Portfolio (total=100%) 9 0 1 1 2 3 4 5 6 7 8 r 9 ep 99 ar 0 ep 00 ar 0 ep 0 ar 0 ep 02 ar 0 ep 03 ar 0 ep 04 ar 0 p 05 ar 0 ep 06 ar 0 p 07 ar 0 p 08 ar 0 9 Equity Ma S M S M S M S M S M S M Se M S M Se M Se M Large Cap Growth 12.0% GE Diversi ed Portfolio Large Cap Value 14.0%Source: FactSet Research Systems; Baird analysis. Mid Cap 8.5%The following indices are used to represent the diversified portfolio: Large Cap Growth: Russell Small Cap 3.5%1000® Growth Index; Large Cap Value: Russell 1000® Value Index; Mid Cap: Russell Midcap® International 14.0%Index; Small Cap: Russell 2000® Index; International: MSCI EAFE; Taxable Fixed Income:Lehman Intermediate US Govt/Credit Index. Satellite: MSCI Emerging Markets Index, Barclays Taxable Fixed Income 40.0%Capital US Corporate High Yield bond Index, DJ-AIG Commodity Index, DJ Global Real EstateIndex. Russell® is a trademark of the Frank Russell Company. Satellite 8.0% -2-
this 10-year period. GE declined at a In Table A, Investment I averages a 7.1% annual rate with 28.3% volatility, 10% return but is the more volatile while the diversified portfolio generated investment, increasing 50% one year and a modestly positive annual return of decreasing 30% the next. Investment II 3.8% with much less volatility (10.6%). also averages a 10% return; however, it Importantly, this is not an isolated case. is less volatile, up 15% and 5% in the Baird has calculated similar results for two years, respectively. dozens of companies, including Procter As Table B shows, Investment II, the less & Gamble, Cisco Systems, J.P. Morgan volatile of the investments, generates Chase, Disney, Coca-Cola, and Merck. a much higher compounded growth In many of the “what-if ” analyses we rate of 9.9%, compared with 2.5% for conducted, the diversified portfolio Investment I. As a result, a $1,000,000 outperformed the single stock position, investment in Investment II grows to and in all cases the diversified portfolio $1,207,500 in two years. That’s over had lower volatility. $150,000 more than Investment I, So why does a diversified portfolio simply because of the investment’s oftentimes outperform a single stock lower volatility. In summary, the more position? The answer lies in the lower an investment’s return fluctuates year by volatility. As our study and others like year (i.e., the higher the volatility), the it have indicated, greater volatility in a greater the drag on the compounded portfolio reduces compounded growth growth rate and the lower the future rates and future wealth. The example wealth. Thus, controlling volatility and in the tables below illustrates this point risk through proper diversification does through two hypothetical investments matter in portfolio management. that generate the same average annual While investors may be tempted to return of 10%, but with varying levels hold a concentrated stock position in of volatility. the hope of greater profit, they may fail to understand that they are not being compensated for taking this risk. InTABLE A: theory, stocks are riskier investments thatAverages Can Be Misleading should provide higher returns than less- Investment Year 1 Year 2 Average Volatility risky investments like Treasury securities. I 50% -30% 10% 40% However, the risk/reward premium turns against the investor when too II 15% 5% 10% 5% few stocks are owned, and especiallyTABLE B:Why Volatility Matters Investment Original Investment Year 1 Year 2 Compounded Growth Rate I $1,000,000 $1,500,000 $1,050,000 2.50% II $1,000,000 $1,150,000 $1,207,500 9.90% -3-
when the investor holds a single or positions. A few of the most commonDo Today’s Low Capital Gains large, dominant position. Returns reasons investors don’t sell areTax Rates Matter? become too reliant on the fortunes of summarized in Table C below.It’s widely agreed that tax one company (exposing the investor Although many of these reasons areconsiderations, while important, to significant company-specific valid in the eyes of the investor, theshould not be the only reason for fundamental risks) and to a single logic supporting diversification ismaking an investment decision. industry (exposing the investor to compelling. We will now turn toNevertheless, investors who sector-specific risks). As a result, it is some ways an investor can successfullycurrently own a large stock clear that investors should choose to diversify and minimize the risk of aposition should consider the diversify a concentrated stock position concentrated position.potential future of capital gains whenever possible.tax rates when contemplating The True Tax Consequencesa sale. Why Are Some Investors of Selling Reluctant to Sell?At 15%, today’s top long-term One of the biggest objections to sellingcapital gains tax rate is lower Despite this compelling argument, a large appreciated stock position isthan it has been since the 1930s. we have found many investors the need to pay income tax on theIn 2011, this rate will sunset and are reluctant to sell concentrated gain. With a cost basis that can be asrevert to the pre-2003 rates,generally 20%2, unless Congress TABLE C:and the president act to keeprates as they are today. According Why Investors Don’t Sellto the budget recently proposed The Rationale for Holding The Logic of Diversifyingby President Obama, this top rate They want to avoid a “certain loss” due to the tax This is perhaps the most prevalent of all reasonswould increase to 20% after 2010. consequences of selling. to hold, yet often, over longer time horizons, an investor can recoup the tax cost and continue toClearly, an increase in the capital build wealth with a lower risk portfolio.gains rate will result in a muchgreater tax burden for those who They assume the future will be like the past. Even if the stock has been successful in the past, no one can predict the future.sell large concentrated positions.Under this scenario, investors They are overconfident in the stock’s prospects There is a misperception that can occur when an (especially if it is their employer). investor works for a company and has been veryshould be aware that they will successful there. Again, no one can predict the future.likely need more time in the They are lured by the possibility of a big win and feel While one may view situations like Enron andfuture to recoup the tax expense their stock is immune from a significant downfall. WorldCom where stocks totally collapsed as isolatedof the sale – all else being equal, events, owners of these equities never anticipatedsuggesting a sale sooner rather what happened to them.than later. They fear they will regret selling the stock if the price By focusing on the long-term potential and lower continues to rise. risk of the new, diversified portfolio, an investor can overcome these regrets. They cannot bring themselves to sell the stock at a The stock may never reach those levels again; it’s price below its former high. They are waiting for the better to put the money to work in a more prudent, stock to “come back.” diversified strategy. They feel loyal to a stock they inherited from a In fact, diversifying that position may be a wiser way trusted family member. to maintain that legacy. They are legally restricted from selling. Even when selling the stock outright is not an option, there can be other alternatives. For more information see sidebar, “Solutions for Restricted Stock Holders.” -4-
low as zero, the tax implications in tolerances, greater volatility in thatSolutions for Restricted dollar terms of a sale can seem single stock, lower tax costs, andStock Holders significant. However, we have already higher lifestyle spending needs.In some cases, corporate insiders shown how a diversified portfolio canmay be prevented from selling build greater wealth with less risk Selling and Diversifyingdue to regulatory constraints, than a single-stock position. In the Diversifying a concentrated positionsuch as prohibition from selling study referenced above, 104 of the 272 doesn’t mean making a minorduring blackout periods or when stocks were down 20% or more in adjustment to the portfolio. Afterin possession of material non- value at the end of 10 years – roughly all, the goal is to significantly reducepublic information. The Securities equivalent to a payment of 15% the volatility caused by a concentratedand Exchange Commission(SEC), recognizing that corporate federal and 5% state long-term capital position, so the diversification willinsiders were greatly restricted gains. Hypothetically, had an investor need to be meaningful. Selling aby these rules, created a pre- sold a position in one of those 104 portion (i.e., partial sale) of aplanned sell program under Rule names at the beginning of the decade concentrated position is better than10b5-1. By adhering to strict SEC and lost 20% to long-term capitalguidelines, insiders entering into doing nothing. However, investors gains taxes, they would have been no must remember the end goal of10b5-1 programs are allowed toexecute pre-programmed sales worse off had they placed the proceeds reducing volatility and risk to theirwhen they would not otherwise under a mattress for the 10 years, wealth, which will often requirebe allowed to do so. and would have been considerably significant, if not total, reductionIn all cases, owners of stock they better off had they invested the of the concentrated position.cannot readily sell should take proceeds in a diversified portfolioa careful look at how the stock Determining how much, if any, despite the significant up-front tax bill.position fits into their overall to continue holding requires aportfolio strategy, and make sure The longer an investor’s time horizon, thoughtful, unbiased review of thethey diversify around the position. the more likely he or she will be able investment prospects for the stock.For example, if an executive has to recoup the entire tax cost. Much It may be that the best approach for a10% of his portfolio in company depends on the size of the tax bill, portfolio is a complete liquidation –stock, the remaining 90% can which in turn is a function of capital and given the potential influence ofbe invested in a way that helps gains tax rates. Investors should keep emotion, a trusted outside advisorcounterbalance the additionalrisk of that position – perhaps in mind that current capital gains tax may need to assist an investor inwith more low-risk securities rates are lower than they have been making this decision.like Treasury bills. The goal is to for the past 70 years. (See sidebar,minimize the portfolio’s overall If the investor is not restricted from “Do Today’s Low Capital Gains Taxvolatility level in order to preserve selling, the fastest way to reduce the Rates Matter?” on page 4.)as much wealth as possible. In volatility and risk in the portfolio isthese cases, a personal Investment Some of the factors to consider to execute the sale in one transactionPolicy Statement can also be when deciding whether to sell and reinvest the proceeds to create aa valuable tool in defining risk include age and health, current balanced portfolio. This is a goodparameters and establishing portfolio assets and how well these way to bring the risk level of theinvestment guidelines. assets are diversified, cash flow portfolio down quickly and efficiently. requirements, and expected portfolio However, for a variety of reasons, contributions and withdrawals. The this isn’t always feasible so a staged optimal sale amount increases with sale may need to be considered. longer time horizons, lower risk -5-
Staged Sales As a result, open window periods areSpecial Considerations for not an issue and regulatory oversight Selling a large position at one time canStock Options is greatly reduced. These arrangements sometimes lead to downward pressureQuite often, investors mentally are binding and will often require the on the stock price, further reducingaccount for stock options approval of the company, so they’re the portfolio’s value. At other times,differently than stocks. In reality, not for everyone, but they can be a it may be too difficult emotionallystock options are equity holdings valuable strategy. (See “Solutions for for the investor to sell in one largeand can constitute a concentrated Restricted Stock Holders” on page 5.)position. However, they present transaction. In these types of cases, aspecial considerations that require staged sale may be most appropriate. Other Ways to Diversifyadditional planning. In a staged sale, the investor sets aThere are tax consequences to For stock owners unable to divest, goal of selling a certain number ofexercising both incentive stock there are several alternatives that may shares of the stock by a certain date.options (ISOs) and non-qualified be appropriate:stock options (NQSOs). One of For example, the investor wishes to sell 12,000 shares of the stock over • Exchange funds allow qualifiedthe greatest is a tax trap that canoccur when an investor exercises the next 18 months. The investor is investors to exchange a concentratedISOs. For example, an investor may willing to sell shares every quarter, position for a more broadlyexercise ISOs and inadvertently meaning there will be six sales during diversified portfolio of stockstrigger the alternative minimum this period. At the end of each quarter, without incurring an immediate taxtax. If the stock subsequently liability. Essentially, investors the investor then would commit toplummets, the investor could be selling 2,000 shares. By making this contribute their appreciated stock toleft with a large AMT bill yet littleto no equity in the stock itself. commitment, the investor has set the a limited partnership in exchange forThe more volatile the stock, the schedule and won’t be swayed by an interest in a diversified portfolio.greater the possibility an investor emotion, market fluctuations or other After a period of time, generallymight get caught in this trap. events that otherwise might keep him seven years, the investor canAs a result, advance planning or her from selling. The emotion has withdraw a pro rata share of theis crucial. Investors should been removed from the transactions portfolio. Exchange funds can beconsult their investment and tax illiquid, do not eliminate capital with a set plan, agreed to by alladvisors before taking action to gains, can be costly, and provide less involved, that every three monthsdiversify a concentrated stock 2,000 shares will be liquidated. diversification than a broadlyoption position. diversified portfolio. In some cases, executives may be prevented from selling at certain times • Charitable Remainder Trusts because they possess insider informa- (CRTs) help further an investor’s tion such as knowledge of corporate philanthropic goals, while providing strategy, earnings reports or other an immediate tax deduction. The non-public information. Timing sales investor transfers the appreciated between these events (known as “open stock to the trust, and in return window” periods) can be difficult receives an annual income stream and leaves insiders open to regulatory from the trust. The trust can diversify scrutiny. In these circumstances, staged the portfolio, but any taxes on the selling through a 10b5-1 plan is one gain are deferred until the income solution. These plans specify how stream is passed to the donor. At the much and when a stock will be sold. trust’s termination, the remaining The sales are executed automatically, assets pass to a charity the investor with no further investor involvement. chooses. The investor cannot reverse -6-