The Hidden Cost of Holding a Concentrated Position - Dec. 2011

1. The Hidden Cost of
Holding a Concentrated Position
Why diversification can help to protect wealth
By Baird’s Advisory Services Research
Executive Summary
Family wealth created by holding a single stock that appreciates
substantially in value over time is fairly common. For example,
senior company executives receive stock or stock options as part of
their compensation, investors benefit from superior appreciation
of one stock relative to the rest of their portfolio, or family members
inherit a large position in a single stock. Regardless of how the
concentrated position is acquired, it results in a disproportionate
allocation of wealth, which exposes the family to undue risk that
should be understood and managed.
Whether investors understand the risks of holding a concentrated
position or not, there is a tendency to hold onto these positions.
Corporate executives may face insider selling constraints or concerns
about how a sale would affect the market price of their company’s
stock. Other investors simply have an emotional attachment to the
stock. Many investors are concerned about the tax implications
of selling.
Despite these seemingly valid reasons, there is a critical point for
most investors and families where the desire for wealth, income
and lifestyle preservation outweighs the need for further wealth
creation. This is especially true when investors approach retirement
or life events during which they will more heavily rely on their
accumulated wealth.
The goal of this paper is to educate investors about the hidden risks
associated with holding significant wealth in concentrated positions,
and to suggest strategies to help mitigate and manage those risks.

2. The Risk/Reward Implications The results of this study showed
Defining Concentrated of a Concentrated Position that over half of the individual
Position Investors who have benefited from stocks underperformed our 60/40
A concentrated position occurs holding a concentrated position often diversified portfolio, and that all of
when an investor owns shares believe that past performance will the individual stocks showed much
of a stock (or other security continue indefinitely, and may find it higher volatility. The average stock’s
type) that represent a large difficult to imagine a downside. While volatility was nearly four times that
percentage of his or her overall it’s tempting to believe a successful of the diversified portfolio. There is
portfolio. The investor’s wealth stock will remain that way, studies no perfect way to know which stocks
becomes concentrated in the show that investments in a diversified will be the winners over the long
single position. Depending on portfolio will produce greater term, and the cost for being wrong
the volatility of the stock, and
long-term wealth than investments can be high. For example, the return
the size of the client’s portfolio, a of 160 stocks failed to keep pace
in a concentrated position, with
position is often considered to be with inflation over the period, and
significantly less risk.
concentrated when it represents 104 of the 272 stocks were down
10% or more of one’s portfolio. In order to better understand the 20% or more in value at the end of
risk/reward tradeoff of holding a the decade.
concentrated stock position, Baird
constructed a hypothetical diversified In fact, the 60/40 diversified portfolio
portfolio1 consisting of 60% equities returned 45% cumulatively over the
and 40% fixed income and compared decade while the S&P 500 was down
it with the 272 individual stocks that 26%. A good example is General
remained consistently in the S&P 500 Electric. The chart below compares
Index for the 10-year period of March the performance of General Electric’s
31, 1999 to March 31, 2009. stock to the diversified portfolio over
Concentrated Equity Position: “What If” Analysis
Ten-year Performance: Stock vs. Diversi ed Portfolio
Growth of a $100,000 Investment Over the Past 10 Years
$200,000 Diversi ed Portfolio
$175,000
GE Diversified
$150,000 $144,908 Portfolio
$125,000 10-year (7.1%) 3.8% Higher
$100,000 Annualized Return Return
$75,000
10-year 28.3% 10.6% Less
GE Annual Volatility Volatility
$50,000 $47,657
$25,000 Diversified Portfolio (total=100%)
9 0 1 1 2 3 4 5 6 7 8
r 9 ep 99 ar 0 ep 00 ar 0 ep 0 ar 0 ep 02 ar 0 ep 03 ar 0 ep 04 ar 0 p 05 ar 0 ep 06 ar 0 p 07 ar 0 p 08 ar 0
9 Equity
Ma S M S M S M S M S M S M Se M S M Se M Se M
Large Cap Growth 12.0%
GE Diversi ed Portfolio
Large Cap Value 14.0%
Source: FactSet Research Systems; Baird analysis. Mid Cap 8.5%
The following indices are used to represent the diversified portfolio: Large Cap Growth: Russell Small Cap 3.5%
1000® Growth Index; Large Cap Value: Russell 1000® Value Index; Mid Cap: Russell Midcap® International 14.0%
Index; Small Cap: Russell 2000® Index; International: MSCI EAFE; Taxable Fixed Income:
Lehman Intermediate US Govt/Credit Index. Satellite: MSCI Emerging Markets Index, Barclays Taxable Fixed Income 40.0%
Capital US Corporate High Yield bond Index, DJ-AIG Commodity Index, DJ Global Real Estate
Index. Russell® is a trademark of the Frank Russell Company. Satellite 8.0%
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3. this 10-year period. GE declined at a In Table A, Investment I averages a
7.1% annual rate with 28.3% volatility, 10% return but is the more volatile
while the diversified portfolio generated investment, increasing 50% one year and
a modestly positive annual return of decreasing 30% the next. Investment II
3.8% with much less volatility (10.6%). also averages a 10% return; however, it
Importantly, this is not an isolated case. is less volatile, up 15% and 5% in the
Baird has calculated similar results for two years, respectively.
dozens of companies, including Procter
As Table B shows, Investment II, the less
& Gamble, Cisco Systems, J.P. Morgan
volatile of the investments, generates
Chase, Disney, Coca-Cola, and Merck.
a much higher compounded growth
In many of the “what-if ” analyses we
rate of 9.9%, compared with 2.5% for
conducted, the diversified portfolio
Investment I. As a result, a $1,000,000
outperformed the single stock position,
investment in Investment II grows to
and in all cases the diversified portfolio
$1,207,500 in two years. That’s over
had lower volatility.
$150,000 more than Investment I,
So why does a diversified portfolio simply because of the investment’s
oftentimes outperform a single stock lower volatility. In summary, the more
position? The answer lies in the lower an investment’s return fluctuates year by
volatility. As our study and others like year (i.e., the higher the volatility), the
it have indicated, greater volatility in a greater the drag on the compounded
portfolio reduces compounded growth growth rate and the lower the future
rates and future wealth. The example wealth. Thus, controlling volatility and
in the tables below illustrates this point risk through proper diversification does
through two hypothetical investments matter in portfolio management.
that generate the same average annual
While investors may be tempted to
return of 10%, but with varying levels
hold a concentrated stock position in
of volatility.
the hope of greater profit, they may fail
to understand that they are not being
compensated for taking this risk. In
TABLE A:
theory, stocks are riskier investments that
Averages Can Be Misleading should provide higher returns than less-
Investment Year 1 Year 2 Average Volatility risky investments like Treasury securities.
I 50% -30% 10% 40% However, the risk/reward premium
turns against the investor when too
II 15% 5% 10% 5% few stocks are owned, and especially
TABLE B:
Why Volatility Matters
Investment Original Investment Year 1 Year 2 Compounded Growth Rate
I $1,000,000 $1,500,000 $1,050,000 2.50%
II $1,000,000 $1,150,000 $1,207,500 9.90%
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4. when the investor holds a single or positions. A few of the most common
Do Today’s Low Capital Gains large, dominant position. Returns reasons investors don’t sell are
Tax Rates Matter? become too reliant on the fortunes of summarized in Table C below.
It’s widely agreed that tax one company (exposing the investor
Although many of these reasons are
considerations, while important, to significant company-specific
valid in the eyes of the investor, the
should not be the only reason for fundamental risks) and to a single
logic supporting diversification is
making an investment decision. industry (exposing the investor to
compelling. We will now turn to
Nevertheless, investors who sector-specific risks). As a result, it is
some ways an investor can successfully
currently own a large stock clear that investors should choose to
diversify and minimize the risk of a
position should consider the diversify a concentrated stock position
concentrated position.
potential future of capital gains whenever possible.
tax rates when contemplating The True Tax Consequences
a sale. Why Are Some Investors of Selling
Reluctant to Sell?
At 15%, today’s top long-term One of the biggest objections to selling
capital gains tax rate is lower Despite this compelling argument,
a large appreciated stock position is
than it has been since the 1930s. we have found many investors
the need to pay income tax on the
In 2011, this rate will sunset and are reluctant to sell concentrated
gain. With a cost basis that can be as
revert to the pre-2003 rates,
generally 20%2, unless Congress
TABLE C:
and the president act to keep
rates as they are today. According Why Investors Don’t Sell
to the budget recently proposed The Rationale for Holding The Logic of Diversifying
by President Obama, this top rate They want to avoid a “certain loss” due to the tax This is perhaps the most prevalent of all reasons
would increase to 20% after 2010. consequences of selling. to hold, yet often, over longer time horizons, an
investor can recoup the tax cost and continue to
Clearly, an increase in the capital
build wealth with a lower risk portfolio.
gains rate will result in a much
greater tax burden for those who They assume the future will be like the past. Even if the stock has been successful in the past,
no one can predict the future.
sell large concentrated positions.
Under this scenario, investors They are overconfident in the stock’s prospects There is a misperception that can occur when an
(especially if it is their employer). investor works for a company and has been very
should be aware that they will
successful there. Again, no one can predict the future.
likely need more time in the
They are lured by the possibility of a big win and feel While one may view situations like Enron and
future to recoup the tax expense
their stock is immune from a significant downfall. WorldCom where stocks totally collapsed as isolated
of the sale – all else being equal, events, owners of these equities never anticipated
suggesting a sale sooner rather what happened to them.
than later. They fear they will regret selling the stock if the price By focusing on the long-term potential and lower
continues to rise. risk of the new, diversified portfolio, an investor can
overcome these regrets.
They cannot bring themselves to sell the stock at a The stock may never reach those levels again; it’s
price below its former high. They are waiting for the better to put the money to work in a more prudent,
stock to “come back.” diversified strategy.
They feel loyal to a stock they inherited from a In fact, diversifying that position may be a wiser way
trusted family member. to maintain that legacy.
They are legally restricted from selling. Even when selling the stock outright is not an
option, there can be other alternatives. For more
information see sidebar, “Solutions for Restricted
Stock Holders.”
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5. low as zero, the tax implications in tolerances, greater volatility in that
Solutions for Restricted dollar terms of a sale can seem single stock, lower tax costs, and
Stock Holders significant. However, we have already higher lifestyle spending needs.
In some cases, corporate insiders shown how a diversified portfolio can
may be prevented from selling build greater wealth with less risk Selling and Diversifying
due to regulatory constraints, than a single-stock position. In the Diversifying a concentrated position
such as prohibition from selling study referenced above, 104 of the 272 doesn’t mean making a minor
during blackout periods or when stocks were down 20% or more in adjustment to the portfolio. After
in possession of material non-
value at the end of 10 years – roughly all, the goal is to significantly reduce
public information. The Securities
equivalent to a payment of 15% the volatility caused by a concentrated
and Exchange Commission
(SEC), recognizing that corporate federal and 5% state long-term capital position, so the diversification will
insiders were greatly restricted gains. Hypothetically, had an investor need to be meaningful. Selling a
by these rules, created a pre- sold a position in one of those 104 portion (i.e., partial sale) of a
planned sell program under Rule names at the beginning of the decade concentrated position is better than
10b5-1. By adhering to strict SEC and lost 20% to long-term capital
guidelines, insiders entering into
doing nothing. However, investors
gains taxes, they would have been no must remember the end goal of
10b5-1 programs are allowed to
execute pre-programmed sales worse off had they placed the proceeds reducing volatility and risk to their
when they would not otherwise under a mattress for the 10 years, wealth, which will often require
be allowed to do so. and would have been considerably significant, if not total, reduction
In all cases, owners of stock they better off had they invested the of the concentrated position.
cannot readily sell should take proceeds in a diversified portfolio
a careful look at how the stock
Determining how much, if any,
despite the significant up-front tax bill.
position fits into their overall to continue holding requires a
portfolio strategy, and make sure The longer an investor’s time horizon, thoughtful, unbiased review of the
they diversify around the position. the more likely he or she will be able investment prospects for the stock.
For example, if an executive has to recoup the entire tax cost. Much It may be that the best approach for a
10% of his portfolio in company depends on the size of the tax bill, portfolio is a complete liquidation –
stock, the remaining 90% can which in turn is a function of capital and given the potential influence of
be invested in a way that helps
gains tax rates. Investors should keep emotion, a trusted outside advisor
counterbalance the additional
risk of that position – perhaps
in mind that current capital gains tax may need to assist an investor in
with more low-risk securities rates are lower than they have been making this decision.
like Treasury bills. The goal is to for the past 70 years. (See sidebar,
minimize the portfolio’s overall
If the investor is not restricted from
“Do Today’s Low Capital Gains Tax
volatility level in order to preserve selling, the fastest way to reduce the
Rates Matter?” on page 4.)
as much wealth as possible. In volatility and risk in the portfolio is
these cases, a personal Investment Some of the factors to consider to execute the sale in one transaction
Policy Statement can also be when deciding whether to sell and reinvest the proceeds to create a
a valuable tool in defining risk include age and health, current balanced portfolio. This is a good
parameters and establishing portfolio assets and how well these way to bring the risk level of the
investment guidelines.
assets are diversified, cash flow portfolio down quickly and efficiently.
requirements, and expected portfolio However, for a variety of reasons,
contributions and withdrawals. The this isn’t always feasible so a staged
optimal sale amount increases with sale may need to be considered.
longer time horizons, lower risk
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6. Staged Sales As a result, open window periods are
Special Considerations for not an issue and regulatory oversight
Selling a large position at one time can
Stock Options is greatly reduced. These arrangements
sometimes lead to downward pressure
Quite often, investors mentally are binding and will often require the
on the stock price, further reducing
account for stock options approval of the company, so they’re
the portfolio’s value. At other times,
differently than stocks. In reality, not for everyone, but they can be a
it may be too difficult emotionally
stock options are equity holdings valuable strategy. (See “Solutions for
for the investor to sell in one large
and can constitute a concentrated Restricted Stock Holders” on page 5.)
position. However, they present transaction. In these types of cases, a
special considerations that require staged sale may be most appropriate.
Other Ways to Diversify
additional planning.
In a staged sale, the investor sets a
There are tax consequences to For stock owners unable to divest,
goal of selling a certain number of
exercising both incentive stock there are several alternatives that may
shares of the stock by a certain date.
options (ISOs) and non-qualified be appropriate:
stock options (NQSOs). One of
For example, the investor wishes to
sell 12,000 shares of the stock over • Exchange funds allow qualified
the greatest is a tax trap that can
occur when an investor exercises the next 18 months. The investor is investors to exchange a concentrated
ISOs. For example, an investor may willing to sell shares every quarter, position for a more broadly
exercise ISOs and inadvertently meaning there will be six sales during diversified portfolio of stocks
trigger the alternative minimum this period. At the end of each quarter, without incurring an immediate tax
tax. If the stock subsequently liability. Essentially, investors
the investor then would commit to
plummets, the investor could be
selling 2,000 shares. By making this contribute their appreciated stock to
left with a large AMT bill yet little
to no equity in the stock itself. commitment, the investor has set the a limited partnership in exchange for
The more volatile the stock, the schedule and won’t be swayed by an interest in a diversified portfolio.
greater the possibility an investor emotion, market fluctuations or other After a period of time, generally
might get caught in this trap. events that otherwise might keep him seven years, the investor can
As a result, advance planning or her from selling. The emotion has withdraw a pro rata share of the
is crucial. Investors should been removed from the transactions portfolio. Exchange funds can be
consult their investment and tax illiquid, do not eliminate capital
with a set plan, agreed to by all
advisors before taking action to gains, can be costly, and provide less
involved, that every three months
diversify a concentrated stock
2,000 shares will be liquidated. diversification than a broadly
option position.
diversified portfolio.
In some cases, executives may be
prevented from selling at certain times • Charitable Remainder Trusts
because they possess insider informa- (CRTs) help further an investor’s
tion such as knowledge of corporate philanthropic goals, while providing
strategy, earnings reports or other an immediate tax deduction. The
non-public information. Timing sales investor transfers the appreciated
between these events (known as “open stock to the trust, and in return
window” periods) can be difficult receives an annual income stream
and leaves insiders open to regulatory from the trust. The trust can diversify
scrutiny. In these circumstances, staged the portfolio, but any taxes on the
selling through a 10b5-1 plan is one gain are deferred until the income
solution. These plans specify how stream is passed to the donor. At the
much and when a stock will be sold. trust’s termination, the remaining
The sales are executed automatically, assets pass to a charity the investor
with no further investor involvement. chooses. The investor cannot reverse
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7. the transfer once it’s done. And, the be entitled to step-up the cost basis of
income stream will not generate as the stock, meaning they could sell and
much wealth as selling the stock and owe little or no capital gains taxes. In
keeping the proceeds. Therefore, the this case, hedging the position may be
CRT is most appropriate for an a better alternative. (See “Other Ways
investor with charitable intentions to Diversify” on page 6.)
or for those who won’t need access
to the principal. It’s All About Protecting
the Wealth
• Hedging alternatives are most often
used by individuals who are restricted A large stock position acquired
from selling their shares, or whose through years of executive
short time horizon makes selling an compensation, superior price
unattractive option. A common appreciation or an inheritance can
hedging technique involves the use produce significant family wealth.
of “collars” or collar-like strategies. At the same time, that wealth may
Hedging strategies are complex and become dangerously concentrated,
can have tax implications for the presenting considerable risks.
investor. Therefore, we encourage As we have discussed throughout this
clients to work carefully with their paper, there are several thoughtful
investment and tax advisors to approaches investors can consider to
evaluate how these strategies fit in the reduce their concentrated position and
context of their overall wealth diversify their portfolio. We encourage
management plans. any clients who hold concentrated
positions to speak with an advisor
When Not to Sell about the available options. Families
Selling usually doesn’t make sense for with concentrated positions should set
those investors who expect to bequeath and execute a professionally prepared
their assets in the near term. Upon an plan to help retain and protect their
investor’s death, the heirs (including family’s future wealth.
the spouse, children and others) may
1
The following indices are used to represent the diversified portfolio: Large Cap Growth: Russell 1000® Growth Index; Large Cap Value: Russell 1000® Value Index; Mid Cap:
Russell Midcap® Index; Small Cap: Russell 2000® Index; International: MSCI EAFE; Taxable Fixed Income: Lehman Intermediate US Govt/Credit Index. Satellite: MSCI
Emerging Markets Index, Barclays Capital US Corporate High Yield bond Index, DJ-AIG Commodity Index, DJ Global Real Estate Index. Russell® is a trademark of the Frank
Russell Company. Indices are unmanaged and a direct investment can not be made into an index. The analysis was performed by Baird’s Advisory Services Research department.
2
Alan R. Sumutka, Andrew M. Sumutka, and Gina S. Margarido. The CPA Journal Online. “Planning for 2008-2010 Zero-Percent Adjusted Net Capital Gain Rate.”
December 2006.
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© 2009 Robert W. Baird & Co. Incorporated. www.rwbaird.com 800-RW-BAIRD MC-25940 First use: 6/09