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Take a Closer Look at Concentrated Equity Positions

Concentrated equity positions come with inherent risks. Such positions can be amassed through ownership or sale of a business, equity compensation, inheritance, or simply by building positions over time through strong market performance. Regardless, investors should consider addressing the significant risk in the form of higher volatility and potential loss of capital that comes with concentrated portfolios before they can cause lasting damage to an investor’s portfolio.

What is a Concentrated Equity Position?

While there is not an exact definition, a concentrated equity position occurs when an investment makes up 10-20%+ of one’s total investable assets. Concentration can result from several factors, including:

• Company stock: Employees who receive stock options or other forms of equity as compensation, or as financial consideration when selling a business. If the employee does not develop a strategy to manage their company holdings, they can quickly find themselves highly concentrated.

• Asset performance: When one investment performs significantly better than the others in a portfolio, or if periodic rebalancing does not occur, an investor may find the value of that asset grew substantially. The investor may now face a concentrated portfolio. Over the past decade, many investors experienced this with investments in the likes of Apple, Tesla, Netflix, and Facebook.

• Intentional concentration: Choosing a particular investment because of strong beliefs that it will outperform other investment options, an investor intentionally invests more money into one asset or sector of the market.

• Correlated assets: Investors do not have to just own one stock to be considered concentrated. In fact, it’s common to be overly concentrated due to a high correlation among several different investments within the same industry, asset class, or region (e.g. U.S. technology stocks).

Why is Diversification Important?

Concentrated equity positions have higher levels of stock-specific risk (“unsystematic risk”) as compared to diversified positions which carry market risk (“systematic risk”). Unsystematic risks, by definition, cannot be diversified away and include risks such as new competitors entering the market, regulatory landscape changes, fraudulent activity, and management changes. While investors may be able to anticipate some of these risks, it is virtually impossible to know when and where they might occur.

Investor portfolios with large stock-specific risks face two general hazards: higher volatility and potentially permanent loss of capital. We looked at research on the Russell 3000 index to highlight these hazards.

• Higher Volatility: Individual equity positions almost always exhibit higher volatility than the broader market. 99% of the Russell 3000 index stocks had a lifetime volatility greater than the index’s volatility.

• Permanent Loss of Capital: Many companies ultimately succumb to the stock-specific risks they face. Over the past thirty years, 38% of the companies in the Russell 3000 Index have suffered permanent loss of capital (defined by losing more than 75% of their value and never recovering to 50% of their original value).

Managing a Concentrated Position

Oftentimes, simply selling – at least in part – a concentrated position over time may make sense, even though doing so can lead to the holder paying capital gains taxes. Doing so in conjunction with selling call options to generate additional income for the investor is a common strategy. However, there are other ways to manage the risk associated with concentrated stock positions, including:

• Exchange funds: These funds offer investors the opportunity to contribute shares of a single company’s stock in exchange for shares of a diversified pool of such stocks.

• Equity collars: This is an options strategy created by selling a call option (and thus future upside in the stock above a certain level) and using the funds to purchase a put option (option to sell the stock at a guaranteed minimum level), which acts as a hedge against downside risk. 

• Funding charitable donations: depending on an investor’s level of charitable giving, concentrated equity positions with large embedded gains can be a great source of funding for future donations through vehicles such as donor-advised funds.

How We Can Help

Though overly concentrated positions are risky, they do not have to derail your long-term financial well. At Klingman & Associates, we can help you navigate the risks associated with these positions.