For this post, I want to focus on a topic that is relevant to a vast majority of the people I serve – managing concentrated stock positions.
Over the years I’ve seen stock concentration create significant wealth and unlock new financial possibilities for many individuals and families. I have also seen single stock positions swiftly destroy vast amounts of wealth. That said, I believe it’s important to manage this financial risk by having a thoughtful strategy for trimming single stock concentration and then using these proceeds to continue building wealth across a mix of diversified assets.
There are a variety of factors for how quickly you sell down a concentrated stock position including your outlook for the company, your personal financial objectives, and how large of a stake your company stock is relative to the other assets you own. When you work for a company, it’s natural to have an optimistic view on the company going forward. One of my responsibilities is to be an objective party who looks out for your best interests. That said, I take into account your personal financial objectives, as well as historical data on single stock positions to inform my recommended sales plan.
One data point that is worth sharing – a research report that studied the lifetime returns of U.S. public stocks dating back to 1926 revealed that just 86 stocks out of over 2,150 stocks, just 4% of the stocks studied, accounted for more than half of the total market gains. So outside of a small percentage of companies, the data says that the odds of holding concentrated stock is not in your favor for long-term wealth creation.
Now with that background, I’ve outlined a few strategies for trimming concentrated stock positions in order of most simple to more complex.
Direct Sale + Set a Gains Budget
While it may seem obvious, a simple strategy that maximizes flexibility shouldn’t be overlooked. Especially if you’ve held shares for over one year and the sale qualifies as a long-term capital gain. Upon sale, you then have full discretion for how you want to reinvest or to spend the cash proceeds.
For individuals who want to retain some exposure to the stock, setting up a rules-based approach, such as an annual capital gains budget (i.e. sell up to $xx,xxx in gains) or a target percentage of your portfolio (i.e. 10% of my portfolio is held in a single stock within 3 years). Once that target is defined, then you know how much you need to sell each year to get there.
Donating to Charity
For individuals with charitable intent, donating stock with large gains is an optimal method to fulfill your donations. The benefits of donating stock are:
If you itemize your deductions, you receive a tax deduction against your income for the value of shares donated.
You avoid capital gains tax and the charity is a tax-exempt organization, so they don’t pay any tax when they liquidate the shares.
Under the new tax law, “clumping” multiple years of planned donations into one calendar year is a great way to maximize the tax benefits of donations. To do this, you can establish a Donor Advised Fund (DAF) through a company such as Daffy, and contribute stock directly from your brokerage account to the DAF. This enables you to capture a larger tax deduction in one tax year and still retain the ability to disburse funds to charitable organizations over multiple years.
Direct Stock Ownership / Custom Indexing
This strategy involves owning individual stocks outright vs. owning these companies through an ETF or a mutual fund. When you own a diversified portfolio, there are “winners” and “losers” within the stocks you own. When you own these stocks outright, you can sell the “losers” and use the losses to offset capital gains on the sale of your concentrated stock position that has built-in gains. This creates a tax-neutral (i.e. you don’t pay capital gains tax) method to transition your concentrated stock position into a diversified portfolio over time.
351 ETF Conversion
This strategy involves funding a new ETF with existing stock positions. This is meant for individuals who own a portfolio of 10+ individual stocks or ETFs that all have large embedded gains rather than one single stock position that makes up a majority of your investment portfolio. For example, maybe your portfolio is a majority of Mag7 tech stocks that have performed exceptionally well over recent years and these positions have now become a larger portion of your portfolio than what you’re comfortable owning. Rather than sell these positions, take the tax hit, and reinvest the cash into a new diversified ETF, this strategy allows you to fund a new ETF “in-kind” with your existing stock positions. No taxes are due upon funding the ETF and the result is that you own one large cap, diversified ETF (similar to S&P 500) within your investment account.
Exchange Fund
Exchange funds are similar to the strategy outlined above, however, you can “exchange” your single stock position for a piece of a diversified portfolio – without having to sell your stock and pay taxes right away. I’ve outlined a high-level of how this works:
You contribute your single stock to the fund.
Other investors do the same with their own stocks.
The fund pools all these stocks together into a diversified basket.
You now own a small share of the basket instead of just your one stock.
These funds also own private real estate (usually 20% of the fund), so it does provide exposure to another asset class as well. Once you exit the fund (often you are required to remain invested for a minimum period of 3-7 years) you now own a diversified mix of stocks that were composed within the fund. It’s important to note this strategy is a tax deferral, not a tax elimination. For anyone interested in learning more about this strategy, you can check out Cache.
Lastly, for individuals with large concentrated stock positions ($5M+), there are a variety of trusts that present attractive tax planning opportunities, such as establishing a Charitable Lead / Remainder Trust or an Intentionally Defective Grantor Trust.
All of these strategies have their own set of pros / cons that are important to evaluate. My intent for this newsletter is to share an educational overview of a few types of vehicles and strategies that may be appropriate for you in the future.
Taxes are an important factor when planning around a concentrated stock position, but they shouldn’t be the only factor. If you’ve had the good fortune of building wealth through the combination of hard work and joining the right company, then my objective is to develop a thoughtful strategy that enables you to continue to grow and sustain wealth and affords you the ability to live a rich life.
As you reflect on how to manage your single stock position, remember this:
“Concentration creates wealth, Diversification preserves it”.