Everyone knows the old saying about not putting all your eggs in one basket. This is especially important for investors, yet we still often find concentrated positions in client portfolios.
Whether these assets were acquired through an inheritance, a liquidity event, an employer compensation structure or the appreciation of a long-held investment, the result may be too much of a good thing. A high concentration of a single investment within a portfolio—one that may even be an outstanding performer—can become a growing investment risk as time goes on. It’s like sitting down at the roulette table in a casino and putting down a good chunk of your net worth on a single number or color. What could go wrong?
Understanding total investment risk
Using a broad definition, total investment risk can be calculated by adding systematic risk and unsystematic risk. Systematic risk, or market risk, represents the risk of loss arising from a potential broad market decline. Unsystematic risk, or idiosyncratic risk, represents the risk of price changes due to the unique circumstances of a specific security.
Total Risk = Systematic Risk + Unsystematic Risk
Unsystematic risks will generally be higher if you have fewer investments in your portfolio. As the number of holdings rise, the volatility of return, or risk, typically falls.
The implications of this conclusion are crucial to expected returns. A high-risk stock does not necessarily have the greatest expected return. Consider a biotech stock with a drug that is in clinical trials to determine its effectiveness. If it turns out that the drug is effective and safe, stock returns should be high. If, on the other hand, the clinical trials are deemed a failure, the stock will fall. However, if an investor buys a fund holding a group of biotech stocks, the sensitivity to trials at a specific company will be partially mitigated.
How to reduce the capital gains dilemma
Investors generally hold concentrated positions for psychological and financial reasons. A common psychological reason is an attachment to the holding because it was a gift from a parent or part of an estate settlement. A common financial reason is to defer paying capital gains.
One way to manage capital gains tax liability is to tackle the issue head on. Once an investor understands the actual versus perceived tax liability, the problem may be more manageable than feared. Consider an investor with a $5 million portfolio that contains a $1 million position with a cost basis of $500,000:
- At a 20% long-term capital gains rate, the sale of the position would generate a $100,000 tax bill.
- The tax cost would represent a 10% cost relative to the position but only a 2% cost relative to the total portfolio.
In this example, the 2% cost to remove the unsystematic risk may be manageable. Alternatively, selling half the position would lower the risk and only cost the portfolio 1%. In the end, a 1% to 2% tax liability is likely more tolerable when the market is up 10% on the year rather than flat or down.
Unwinding concentrated positions can be difficult
Determining the tax liability for unwinding a concentrated position is easy. The hard part is calculating the future benefits of diversifying a portfolio. This can only be accomplished using return assumptions for both the single security and the overall market. As a result, the ultimate decision to sell or hold needs to come down to other factors such as risk tolerance, total portfolio risk, costs, and time horizon.
- Investors with higher risk tolerance may be comfortable with more concentrated positions.
- A portfolio with singularly large or multiple concentrated positions will increase total portfolio risk.
- Both tax liability and transaction costs should be determined before reducing a position.
- A long-term time horizon may compound the unsystematic risk over time. Hence, reducing the position sooner is generally the most prudent decision.
Plan ahead
Here are some commonly used solutions that may fit your liquidity needs and risk tolerance:
1. Tax-efficient gifting
- Instead of gifting cash, consider donating long-term appreciated securities. Capital gains taxes are eliminated when you contribute long-term appreciated assets directly.
- Fund a charitable remainder trust (CRT). A CRT allows an investor to receive a charitable deduction as well as an annual income stream if the client is the beneficiary.
2. Monetization
- Set a long-term diversification plan to reduce concentrated positions over several tax years. Setting a “capital gains budget” will allow your advisor to advantageously reduce positions when rebalancing your portfolio throughout the year. In addition, if in any year your income declines, you may find it beneficial to sell a larger portion of your concentrated position.
3. Hedging
- Use derivatives (puts, calls and collars) to reduce the risks of a concentrated position. This solution, however, may be complex and costly.
4. Tax-efficient diversification
- Tax loss harvesting strategies help investors balance the capital gains they are willing to realize against an acceptable deviation from their intended market exposure. Direct indexing can be a powerful tool to facilitate tax loss harvesting—by enabling investors to own individual securities directly rather than through a fund, direct indexing provides the flexibility to selectively sell and replace securities with gains or losses while maintaining the investor’s intended market exposure.
- Cash additions to the portfolio (via dividends, interest, or additional funds) organically diversify concentrated positions.
History reminds us that high-quality companies can disappear. Whether through competitive innovation (JCPenney, Eastman Kodak and Blockbuster Entertainment), scandal (MCI WorldCom and Enron), acquisition (Tiffany & Co and Mattel) or market duress (Lehman Brothers) it is easy to recall how a once-proud large company’s stock or bond prices were quickly decimated.
Although investors may profit from holding large quantities of a specific asset, it is important to recognize the risk and consider strategies to offset concentrated positions.
This material should not be construed in any way as investment, tax, estate, accounting, legal or regulatory advice. Any description of tax consequences set forth herein is not intended as a substitute for careful tax planning.
Charles R. Johnson, Wealth Director, Fiduciary Trust International is responsible for developing investment and trust relationships with families and organizations. He works closely with the Trust and Tax planning group to help clients determine optimal asset allocation and transfer strategies.