There are lots of reasons why you might find yourself holding a concentrated position — inheritance, selling your business for stock, as part of your executive compensation or just through shrewd investing.
Regardless of how it happened, it's not always best to leave all your eggs in one basket for too long. If the stock in which you're concentrated were to decline significantly, the impact on your wealth and the financial fortunes of your family could be devastating.
In the recent past, we've witnessed large companies like Bank of America, GM and Netflix all suffer sharp declines in their stock prices. For example, between December 2007 and March 2009, Bank of America's stock dropped 92% — a loss that would've been catastrophic for an investor overly concentrated in that position.
Clearly, diversification is the solution. But doing so while effectively managing the underlying tax costs associated with reallocating your assets can be challenging.
Before you can take action to diversify your portfolio, you need to identify what your primary concerns are. They might include:
Once you've identified the things that concern you most, you can use them to help determine the diversification strategy that's right for you.
There are three main ways to address a concentrated position.
Cash out from a concentrated position and diversify your portfolio to both reduce risk and take advantage of the best federal long-term capital gains rates available. There are several ways to approach this:
1. Sell when the price is within a set of parameters, timing intervals or dollar targets that you believe make for a good closing position. Part of this strategy can also involve using limit orders and writing covered calls to take advantage of lower long-term capital gains rates.
2. Agree to deliver shares of the stock at a future date, in return for discounted proceeds now. This allows you to defer capital gains and possibly benefit from the appreciation of the underlying stock.
3. Take advantage of a 10b5-1 trading plan. Rule 10b5-1 of the Securities Exchange Act of 1934 allows an insider to sell regularly and diversify without breaking insider trading rules. You must set up a trading plan for selling a predetermined number of shares at a predetermined time. However, once the plan is agreed upon, you can't make changes, other than to end it.
Charitable giving strategies can delay tax liabilities and lower the amount of capital gains tax due, while also allowing you and your family to build a legacy of philanthropy. Structures for doing so include:
1. Forming a charitable remainder trust. Money is placed into an irrevocable trust that allows you, as the donor, to receive annual payments for a specific time period with the remainder interest passing to charity.
2. Creating a private foundation. A nonprofit, grant-making entity is organized with the purpose of fulfilling your charitable objectives.
3. Establishing a donor-advised fund. This would involve creating a fund within an existing charitable organization. It's similar to a private foundation, but with less administrative oversight required.
If you don't want to sell a concentrated asset because of emotional ties or the tax costs associated with selling, you can borrow or use derivatives to keep some of the asset while generating funds with which you can diversify. You could:
1. Borrow and reinvest. Essentially, you use the concentrated positions as collateral on a loan that you'd then use to diversify the portfolio.
2. Pay for a protective put option. Protect yourself from losses by buying the right to sell the concentrated security at a certain price.
3. Sell covered call options. Increase income from the security by agreeing to sell the security at a fixed price. This would, however, limit your ability to benefit from the stock's appreciation.
4. Use an equity collar. Sell a call option to buy a put option to get downside protection
You can also reduce the risk to your portfolio by moving securities to family members, typically by forming a trust, like a grantor retained annuity trust. These techniques don't offer diversification themselves, but can offer investment ideas with alternative timelines, risk and tax implications.
Older investors should keep in mind that at death there is a step up in cost basis of their assets. For this reason, holding onto the security but hedging the position may be a viable solution.
It is extremely rare to choose a single strategy for moving from a concentrated position to a diversified portfolio. Your overall approach will depend on the specific details of the investment and your complete financial situation. What is most critical is that you combine the practical knowledge of the various diversification strategies with a thorough understanding of your own needs and concerns.
This material is provided for illustrative/educational purposes only. This material is not intended to constitute legal, tax, investment or financial advice. Effort has been made to ensure that the material presented herein is accurate at the time of publication. However, this material is not intended to be a full and exhaustive explanation of the law in any area or of all of the tax, investment or financial options available. The information discussed herein may not be applicable to or appropriate for every investor and should be used only after consultation with professionals who have reviewed your specific situation. BNY Mellon Wealth Management conducts business through various operating subsidiaries of The Bank of New York Mellon Corporation. ©2016 The Bank of New York Mellon Corporation. All rights reserved.