What is a Concentrated Position?
Investors have a concentrated position when they own shares of a stock or another type of security that make up a significant portion of their overall portfolio.
In a single position, the wealth of the investor becomes concentrated.
A position is concentrated when it represents 10% or more of one's portfolio, depending on the stock's volatility and the client's portfolio size.
Ways to Address a Concentrated Position
There are a few different ways that investors can address a concentrated position:
Sell and Diversify
One way to address a concentrated position is to sell some of the shares of stock and reinvest the proceeds in a diversified investment portfolio.
Several ways include:
- Sell when the price is within a set of parameters, dollar targets, or timing intervals, as you think that makes for good closing positions.
- In return for discounted proceeds, agree to deliver a share of the stock at the following date.
- Take advantage of a 10b5-1 plan, which lets an insider regularly sell and diversify without breaking insider trading rules.
Charitable Giving
Another way to address a concentrated position is to give some of the shares of stock to charity.
This includes making a charitable remainder trust, a private or donor-advised foundation.
Diversify Through Borrowing or Derivatives
A third way to address a concentrated position is to borrow against the stock or use derivatives.
This includes borrowing and reinvesting, paying for a protective put option, selling covered call options, and using an equity collar.
Why Is a Concentrated Position Risky?
A concentrated position can be risky for a few reasons:
- The value of the concentrated position may fall sharply, and it could take longer to recover.
- A company's stock price might be more volatile than the market as a whole.
- Investors with a concentrated position in one stock may need help selling it quickly if they need cash.
- Your assets are more correlated and prone to a downturn in the market, sector, company, or industry.
- Owning a large percentage of your holdings in a single company, which is on the rise, allows you to build wealth instantly. However, the same volatility can bring you down if something goes wrong.
Strategies to Reduce Concentrated Position
Several strategies can be used to reduce risk from a concentrated position:
Net Unrealized Appreciation
The only available strategy to those with employer stock in their 401(k) is the net unrealized appreciation (NUA), which can be significantly effective if properly used.
The NUA lets you collect employer stock from the same employer retirement plan to be treated and taxed as a non-qualified asset moving forward rather than being subject to the higher ordinary income rates on distributions.
Sell Incrementally
Selling shares of a concentrated position incrementally over time can reduce risk while still taking advantage of market conditions and achieving financial goals.
Use of the Blind Trust
A blind trust is an arrangement in which a third party, such as a bank or trust company, holds and invests assets for the benefit of another person without that person's knowledge or input into the investments.
In a blind trust, you can freely choose when and how much you sell.
Public figures often use blind trusts to avoid conflicts of interest and individuals with concentration risk who wish to have someone else manage their investments.
Using Options or Stop Loss Orders
Options and stop-loss orders can be used to protect against downside risk in a concentrated position without selling the stock.
Options grant the owner the right but not the responsibility to buy or sell an underlying asset at a defined price on or before a specific date.
A stop-loss order is assigned to a broker to sell a security when it reaches a specific price.
Exchange-Traded Funds
An exchange-traded fund (ETF) is an investment fund that holds assets such as bonds, stocks, or commodities and trades on an exchange.
ETFs are related to mutual funds but are traded on an exchange like a stock.
Exchange funds may let you transfer your concentrated stock to a specific fund that is tied to a particular index, which, once transferred, you will not have access to it for a given period.
Gifting Appreciated Stock
Gifting appreciated stock to a charity can reduce a concentrated position while also getting a tax deduction.
When you gift appreciated stock, the charity sells it and uses the proceeds to fund its programs.
You can reduce the total value of the stock on your taxes, and you will not have to pay tax from capital gains on the appreciation.
Bottom Line
A concentrated position can be risky, but some strategies can be used to reduce that risk.
Blind trusts, stop-loss orders, and gifting appreciated stock are just a few strategies that can be used.
It is important to speak with a financial advisor before taking action to see if reducing a concentrated position is right for you.
FAQs
1. What is a concentrated position?
A concentrated position is when a large percentage of your holdings are in a single company.
2. What are some strategies to reduce a concentrated position?
Some strategies to reduce a concentrated position include selling incrementally, exchange-traded funds, using a blind trust, and gifting appreciated stock.
3. Why is it risky to have a concentrated position?
A concentrated position is risky because if the company's stock price decreases, you will lose a large percentage of your investment.
4. How can I reduce my concentrated position?
You can reduce your concentrated position by selling some of your shares, using a blind trust, or gifting appreciated stock.
5. When should I diversify?
It would be best if you diversified when you have a large percentage of your holdings in a single company. Diversifying will help to reduce your risk.
