Managing a concentrated position

One of the more difficult conversations we have with clients begins with a statement like this:

"I know I probably own too much of this stock, but it has made me a lot of money. I just can't bring myself to sell it."

It is a common dilemma.

Many successful investors accumulate significant wealth through a single investment. Perhaps they founded a business, worked for a company that rewarded employees with stock, inherited a concentrated position or purchased shares years ago that appreciated far beyond anyone's expectations.

While creating substantial wealth is certainly a good problem to have, it also introduces a new risk that is often overlooked: concentration risk.

Success can create risk

One of the greatest misconceptions in investing is that a stock that has performed well in the past is somehow less risky today.

In reality, the opposite is often true.

As one investment grows to represent an increasingly large percentage of a family's net worth, their financial future becomes increasingly dependent on the continued success of a single company.

Even outstanding businesses experience difficult periods. Industries change, new competitors emerge, management teams change, and regulations evolve. No company is immune from unexpected challenges.

History is filled with examples of companies that once seemed untouchable before experiencing dramatic declines. While no one can predict which companies will thrive over the next decade, history reminds us that leadership changes over time.

Taxes should influence the decision but not control it

One of the primary reasons investors hesitate to sell is taxes.

Selling a highly appreciated investment often results in a significant capital gains tax bill. As a result, many investors postpone the decision year after year.

While taxes are certainly an important consideration, they should not become the only consideration.

One question we often ask clients is simple:

"If taxes were not an issue, would you still choose to have this much invested in one company?"

If the answer is no, then taxes may be driving the investment decision more than sound portfolio management.

Diversification does not have to happen overnight

Fortunately, diversification is rarely an all-or-nothing decision.

Rather than selling an entire position at once, many investors gradually reduce their exposure over several years. This approach allows gains to be recognized over time while reducing dependence on a single investment.

The timing may also be coordinated with years of lower taxable income, charitable giving strategies or tax-loss harvesting opportunities elsewhere in the portfolio.

The objective is not simply to minimize taxes this year. It is to maximize after-tax wealth over an investor's lifetime.

There are more strategies than simply selling

For investors with particularly large positions, there may be additional planning opportunities beyond simply selling shares and paying capital gains taxes.

One increasingly popular strategy is long short direct indexing. Unlike traditional tax loss harvesting, this approach seeks to generate a consistent stream of tax losses by owning individual securities while simultaneously using long and short positions to maintain market exposure. Those harvested losses may then be used to offset gains recognized from gradually diversifying a concentrated stock position.

Some investors may also benefit from exchange funds, which allow participants to contribute a concentrated stock position in exchange for an ownership interest in a diversified pool of securities. This provides immediate diversification while deferring the recognition of capital gains taxes. These structures do have eligibility requirements, holding periods and liquidity constraints.

Some investors may also benefit from Section 351 exchange strategies, which can offer another way to diversify highly appreciated stock positions. Similar to exchange funds, these structures generally require investors to contribute a diversified basket of securities rather than a single concentrated position. In exchange, investors receive an ownership interest in a more diversified ETF that is fully liquid without immediately recognizing capital gains taxes.

For charitably inclined families, donating appreciated stock to a donor advised fund, charitable remainder trust or other charitable vehicle may eliminate capital gains taxes on the donated shares while generating a charitable income tax deduction. In many cases, these strategies allow families to diversify appreciated positions while supporting organizations that are important to them.

Every situation is different. The appropriate strategy depends on the size of the position, the embedded capital gain, liquidity needs, charitable intent, tax bracket and overall financial objectives.

Behavior often becomes the biggest obstacle

Managing a concentrated stock position is often more about psychology than mathematics.

Many investors become emotionally attached to the investment that created their wealth.

Others fear selling because they worry the stock will continue rising after they diversify.

This fear of missing out can prevent otherwise rational investment decisions.

Ironically, investors often diversify every other area of their lives. They diversify their income sources, insurance coverage, banking relationships and even real estate holdings. Yet they sometimes allow one investment to dominate their financial future.

A portfolio should reflect your goals, not your history

There is an important distinction between how wealth is created and how wealth is preserved.

Building wealth often requires concentration. Preserving wealth usually requires diversification.

The investment that helped create financial independence is not necessarily the investment that should carry an investor through retirement.

As financial advisors, our objective is rarely to predict which stock will outperform next year. Instead, it is to build portfolios that provide a high probability of helping clients achieve their long-term financial goals while managing unnecessary risk.

Final thoughts

A concentrated stock position is often a sign of investment success, not investment failure. The challenge is deciding when that success has become too large a portion of your overall financial picture.

There is no one-size-fits-all solution. For some investors, gradually selling shares over time may be the appropriate answer. Others may benefit from more sophisticated planning strategies such as long short direct indexing, exchange funds, Section 351 exchanges or charitable planning.

The decision should rarely be driven by taxes alone or by emotion alone. Instead, it should consider your overall net worth, income needs, charitable goals, estate plan, risk tolerance and long-term objectives.

Diversification does not guarantee better returns, but it can help reduce the risk that a single company, regardless of how successful it has been in the past, determines your family's financial future.

Sometimes the hardest investment decision is not deciding what to buy. It is deciding when it is time to diversify.

Reid Schwartz is a columnist for The Item and co-founder of Creech Schwartz Wealth Management in Sumter, where he works as a financial advisor helping individuals, families, businesses, and nonprofits plan for long-term financial success.

*Tax and accountancy services are not available through or provided by Creech Schwartz Wealth Management or &Partners LLC.

This article is for educational purposes only and not to be interpreted as tax or legal advice. Any tax planning strategies discussed by Creech Schwartz Wealth Management will be in conjunction with your tax/legal professional.

Securities and investment advisory services offered through &Partners LLC, a broker-dealer and investment adviser registered with the U.S. Securities and Exchange Commission and member FINRA, SIPC.