Diversifying a portfolio sounds reasonable and wise, but it turns out that making the move comes with a number of challenges. This article addresses what happens with a "concentrated" stock position in a portfolio.

The following article is from Jon Adams, CFA, who is senior vice president, chief investment officer, and John Campbell, JD, CLU, a SVP, chief wealth strategist, at US firm Calamos Wealth Management. The editors are pleased to share these views on the topic of concentrated stock positions, and what to do about them. As ever, the editors don’t necessarily share the views of guest writers. We invite debate and conversation, so email tom.burroughes@wealthbriefing.com and amanda.cheesley@clearviewpublishing.com

Investing can be an emotional journey, especially if you have created wealth through a single stock whether it be through compensation, personal connections to a business or a fortunate early investment. Deciding when or even if to diversify can be challenging. There are multiple ways to approach a concentrated position, and considering both planning and investment angles will help identify a solution that aligns with investors’ goals and needs.

What is a concentrated position?

When an investor holds more than 10 per cent of their portfolio in a single stock, this is referred to as a concentrated position. If this single stock declines significantly in value, it can leave the investor in a vulnerable position.

Potential risks 
When considering the potential risks of a concentrated stock position, it’s important to recognize several key factors that might prompt an investor to diversify: 
-- Volatility;  
-- Long-term risk; and 
-- Reduced return.

Solutions for managing risk in a concentrated stock position
See below for a comparison of how diversified portfolios can dramatically reduce potential risk while keeping a compelling return within reach, versus a single stock position.

Gifts to charity
Charitable giving offers several strategies for managing concentrated stock positions while providing tax benefits and supporting worthy causes. 

Outright gifts to charity allow donors to receive immediate charitable deductions, which can offset taxes on realized gains from selling non-gifted stock. This approach provides immediate charitable impact, reduces the taxable estate, and offers income tax mitigation

Charitable gift annuities present a unique planning strategy where donors enter into an agreement with a nonprofit organization. The donor receives lifetime payments until death, while the organization retains the donated assets. This method combines immediate charitable impact with a retained income stream, charitable deductions, and estate tax reduction and is especially effective with highly appreciated assets with a low-cost basis.

Charitable remainder trusts (CRTs) are tax-exempt irrevocable trusts that provide partial tax deductions. The grantor makes a donation, and the trust dispenses income to the grantor or named beneficiaries for a specified period. Afterward, the remainder is distributed to designated charitable beneficiaries. CRTs offer delayed charitable impact, income retention, tax benefits, and the opportunity to leverage deductions to offset capital gains from selling concentrated stock

Conservation easements are voluntary legal agreements restricting future land use or development on a property. This strategy preserves natural habitats, provides charitable deductions, reduces the taxable estate, and can offset capital gains from stock sales. However, it requires using a land trust, annual property inspections, and adherence to "protected-in-perpetuity" tax regulations.

Investments
There are several investment strategies available to potentially mitigate concentration risk.

Options contracts give buyers the right, but not the obligation, to buy or sell an underlying asset at a set price and date. They offer hedging opportunities, income streams, and potential tax mitigation, but come with complexity and tax considerations.

Exchange funds are pooled investment vehicles structured as partnerships, allowing investors to diversify their positions while deferring capital gains taxes. These funds offer non-taxable entry and exit, but require a seven-year holding period and substantial minimum investments.

Direct indexing uses losses generated in a portfolio to offset taxable gains on concentrated stock sales. It can mirror index composition, offering tax mitigation, diversification, and customization for goals and values. This approach can be built around legacy positions but requires a minimum level of assets for customization.

Prepaid variable forward contracts (PVFCs) allow investors to receive 75 to 90 per cent of a stock's current market value in exchange for a variable number of stocks at a future date. PVFCs provide immediate liquidity without immediate taxation, defer capital gains taxes, and allow cost-effective diversification. However, they may attract IRS scrutiny due to their nature and the parties involved.

Income tax
Tax planning may have an important role in managing concentration risk.

Tax-free exchanges entail swapping unencumbered, highly appreciated non-stock assets for like-kind assets to facilitate diversification. This strategy offers tax deferral and can aid in portfolio diversification and estate planning. However, it results in deferred tax liability and requires adherence to strict IRS rules and timelines.

Tax-loss harvesting mitigates taxes by offsetting realized taxable gains from concentrated stock sales with losses from selling other securities. This facilitates tax-efficient rebalancing but has limitations on loss utilization and requires adherence to "wash-sale" rules.

Tax basis "step-up" strategies involve appreciable assets held at death receiving a tax basis increase to fair market value upon the holder’s death. This reduces potential tax liability on subsequent asset sales. For irrevocable grantor trusts holding appreciated assets, exchanging low-basis assets for higher-basis assets of equal value may be beneficial.

Asset-based lending uses concentrated stock as collateral to invest proceeds, providing liquidity without selling the stock and facilitating diversification. However, it restricts the use of collateralized assets and may require additional collateral if asset values decline.

Structured sales involve systematically selling concentrated stock over time, mitigating taxes through smaller liabilities from gradual sales rather than a large lump-sum sale. This approach offers systematic diversification but maintains concentration risk in the short- to intermediate-term.

Net unrealized appreciation (NUA) strategies allow for reduced taxes on company stock held inside qualified retirement accounts. They enable paying ordinary income tax only on the cost basis of employer stock in retirement plans, with lower capital gains tax on subsequent sales. NUA treatment requires a triggering event – for example, retirement, death or disability – and typically involves a lump-sum distribution of company stock with remaining assets rolled into an IRA.

Conclusion
It’s important to consider both planning and investment strategies individually and together, as they may effectively reduce risk, mitigate tax impact and help achieve your goals.

Disclosure
Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Calamos Wealth Management LLC), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.