- Having a high concentration of your wealth in a single stock—no matter how great a company, is very risky and does not constitute a retirement plan.
- A well-diversified portfolio may not always outperform a hot single stock, but it significantly reduces the risk of suffering a catastrophic permanent loss.
- Diversifying away from a concentrated stock position should be based on a long-term plan and tax strategy—not randomly adding additional stocks and other assets to your portfolio.
Most investors know about the merits of diversification. But, in our part of the country it’s not unusual for successful professionals to have the majority of their wealth tied up in stock of Amazon, Microsoft or Google. Many are employees of these high-flying technology firms and they can amass significant holdings in their company’s stock over time. Since they tend to believe strongly in their employer’s products and services, they’re inclined to accumulate and hold onto their shares rather than sell.
That’s understandable, but having all of your eggs in one basket—no matter how great the basket, could have a detrimental effect on your long-term financial goals and retirement. History is replete with stories about once mighty companies that later faltered or went bankrupt, taking their investors, employee shareholders and their families down with them. Remember Enron, the energy and commodities behemoth of the 1990s? At its peak, Enron had 22,000 employees and $111 billion in revenues before massive fraud came to light in 2000 and the company went bankrupt, wiping out billions of dollars of accumulated lifetime wealth in a matter of months.
Amassing a large concentration of a single stock or company may work out very well for a while, but it is not a long-term retirement plan. That’s because a single stock could fall out of favor eventually and the downside risk, a total or permanent loss of your hard-earned wealth, could mean a significant change in your retirement lifestyle. Why not hedge your bets by diversifying between other stocks, equity assets classes and even bonds?
Diversification: A hard sell in a booming stock market (it shouldn’t be)
During a long-running bull market, it’s easy to get complacent when you see how well some of your individual stocks, sectors or assets classes are doing. In simplest terms, diversification is a strategy of reducing the volatility (and risk) of your portfolio by holding a wide variety of different investments that have low correlations with each other—not just stocks from different industries (and countries) but investments in different asset classes such as bonds, real estate and cash.
Why would anyone want to be defensive when stocks like Amazon and Apple are up over 30 percent this year? First of all, there is no guarantee that any single company will outperform the overall stock market long-term or even be around 10, 20 or 30 years from now. In fact, less than one-fifth or the original 500 companies that made up the S&P 500 index in 1955 are still in existence today.
At its core, diversification is based on a fundamental belief in the power of the overall stock market. It’s a belief that the collective ingenuity, creativity and profitability of the companies that make up the stock market as a whole will continue to provide growth and return for investors. Sure there will be hiccups along the way, but the patient, long-term investor will always be rewarded for having a well-diversified portfolio.
The Soundmark Approach
When clients who have highly concentrated stock positions first come to us, we treat them just like any other new client. We spend substantial time gaining a complete understanding of their unique financial situation so we can create solutions that are tailored specifically to that client’s goals such as:
- Development of a long-term tax strategy that sells portions of the concentrated stock position over many years based on specific tax bracket goals.
- Selling high-basis shares first, including newly issued stock awards.
- Utilizing tax-loss harvesting if available and warranted.
- Diversifying through other savings or investment options such as 401(k)s.
- Using option strategies.
Incorporate a Tax Strategy
Taxes are generally a significant issue when you have highly appreciated stock positions. Unfortunately paying taxes may be a necessary evil in order to reduce concentrated risk. However, incorporating a tax strategy into your long-term plan and understanding the benefits of diversification can help bring clarity to the benefits of diversification. If you or someone close to you is concerned about high concentration of their wealth in a single stock, please don’t hesitate to contact us.
Todd Flynn, CPA, CFP ® is a Principal at Soundmark Wealth Management, LLC. Todd works closely with physicians, business owners, and other high net worth individuals to help them define their financial goals and implement an ongoing financial planning process.