How To Manage Concentrated Stock

Jason DeBolt, a 39-year old software engineer currently living in Los Angeles, recently announced on Twitter that he is officially retiring from the corporate world. In his tweet, he shared a screenshot of his portfolio that shows a $12M account balance, all of which is in Tesla (TSLA) stock (currently priced at $850/sh). How To Manage Concentrated Stock

Jason Debolt Tsla

Jason originally purchased 2,500 shares at $7.50 in 2013. His split-adjusted cost basis for this position is $18,750, currently worth $2.2M. His total position is 14,850 shares with a cost basis of $58/share.

He intends to margin borrow on his account up to $3M, but no more than 8% of his total liquid assets, so he can meet his spending needs while never selling his TSLA shares. He has repeatedly stated that has is all-in on both TSLA and Elon Musk.

And who can blame him? It took a significant amount of trust and risk-tolerance to make it this far. If either of those attributes were to fail, he wouldn’t be sitting where he is today.

It is also important to note that concentrated positions like this are a quick and effective way to achieve wealth. Plenty of intelligent people understand this. Owning equity cannot be understated. However, for every Jason DeBolt out there, there are millions of other investors that weren’t so lucky. Further, keeping concentrated positions like this is also a very easy way to lose it. Diversifying to stay rich is never a poor investment decision.

So, how much more can TSLA appreciate? Nobody knows, but its stock is currently priced for very high expectations. It is currently trading at 212 times its full-year 2021 earnings! In fact, TSLA stock appreciated 720% in 2020 alone.

TSLA stock can certainly continue to appreciate from its current levels, but I would suspect that the odds are stacked against it. Jason hit the jackpot and the prudent move would be to diversify his holding so he doesn’t risk losing a significant amount of his wealth due to his concentrated stock position. Of course, this is much easier said than done.

But, what is the official definition of a concentrated stock? Definitions vary, but many financial experts say that a concentrated stock position is one that comprises 20% or more of the total value of your overall investment portfolio. Concentrated stock positions can arise for a number of reasons.

A typical situation surrounds owning employer stock. Regardless of the circumstances, it’s crucial to have a strategy for these concentrated positions to maximize the stock’s benefits and minimize the risks. 

The risks of concentrated stock positions 

There are several potential risks associated with concentrated stock positions. The main risk lies in the single stock aspect of the position. This portion of your portfolio can have an undue level of influence over your investment returns due to its size. If the stock falters or encounters bad news that drives the price down, the impact on the value of your portfolio can be severe. 

While your concentrated stock position may have done well (probably a big reason why the position is as large as it currently is), it will most likely not continue doing well forever. In fact, it certainly going to falter at some point. While total stock market is relatively volatile, individual stock positions are extremely volatile.

Holding Concentrate 1
Sources: Northern Trust Research, Morningstar, FactSet

In many cases, concentrated positions are owned by employees of a company who have acquired the shares through stock compensation programs such as restricted stock units, a stock grant, stock options, or as their employer’s matching contribution to their 401(k) account. If the stock goes down due to problems with the company, you may find yourself with both a smaller portfolio and without a job in extreme situations. A concentrated stock position in your employer’s stock ties a large portion of your financial well-being to the financial health of your employer. 

Beyond the stock of your employer, a concentrated stock position might arise from other reasons. One such reason might be an inheritance. Perhaps a parent or other relative had a large position in a particular stock and left some or all of it to you. 

A concentrated stock position can also arise when an investor has held a stock for a long time over which it has experienced significant gains. 

Regardless of how you came to acquire the concentrated stock position, it’s essential to look at how this position impacts your overall investment portfolio, including the level of risk it adds. 

Sometimes investors may feel a sentimental attachment to the stock, especially if its growth has fueled a marked increase in their net worth. It’s critical to make investment decisions without emotion and to focus on the best moves for your portfolio and your financial future. 

Employee stock compensation plans 

Here are the typical stock compensation plans offered by employers and some issues to be aware of if some or all of your concentrated stock position is tied up in one of these plans. 

Restricted stock units (RSU)

RSUs are issued to employees and typically have a vesting period during which the underlying shares cannot be sold. The units are usually issued on a specified schedule, often based upon the employee and/or the company achieving certain milestones. The vesting schedule will specify when the shares revert to the employee, who can then hold the shares or sell them if they wish. 

If the shares are held for at least a year after they are delivered to you, any gains are taxed at preferential long-term capital gains rates.  

Stock options

Stock options are another form of stock-based compensation offered to employees by some companies. In this case, the employee can purchase the associated number of shares at a given price after the date specified in the option. If the price of the stock is lower than the option strike price, they can expire worthlessly. 

Once the option is exercised, if the shares are held for at least a year prior to being sold, the capital gains are taxed at preferential long-term capital gains rates. Incentive Stock Options (ISO) and Non-qualified Stock Options (NSO) have different parameters and requirements. 

Matching in a 401(k) plan

Some employers use company stock to match employee’s contributions to the plan. This is less common than in the past. Additionally, employees with at least three years of experience can diversify away from the company shares into other selections within the plan if they choose. 

Other types of stock compensation plans such as stock grants, stock purchase plans, and others can also contribute to the accumulation of a concentrated stock position. In all cases, it’s important to understand any restrictions these plans might impose upon your ability to sell shares, and of course, any tax issues surrounding the plan. 

There may be restrictions on your ability to sell shares, including the number of shares that can be sold and the timing of when you are eligible to sell. These restrictions are more common for company insiders and officers. When looking to reduce a concentrated position, you must keep any restrictions of this type in mind. 

How to manage your stock position

There are several alternatives investors can consider in managing concentrated stock positions. The best option will depend upon your situation, including how the shares are held.   

Sell shares immediately

Selling some or all of the shares immediately is the quickest way to reduce a concentrated stock position. If the shares are held in a taxable account, the sale can trigger significant capital gains resulting in a sizable tax bill for you.

While this may be terrifying to some, it may be the best option. U.S. Federal capital gain rates are among the lowest in history.

Capital Gains Rate History
SOURCE: WOLTERS KLUWER TAX & ACCOUNTING, MOTLEY FOOL

And depending on which state you reside in, you will also have to consider state and local tax rates. California, of course, is historically expensive, but even that should be enough to dissuade individuals from considering selling now.

That said, some experts think that capital gains taxes may increase under the new Biden administration, so this may be a good time to realize long-term capital gains. 

Sell shares over time

Another alternative is to sell a portion of the position over time. This might be part of your portfolio’s periodic rebalancing plan. If applicable, you might be able to offset some of the gains with tax losses on the sale of other holdings realized in the process. 

Exercise options

Suppose employee stock options are involved in this concentrated position. In that case, you will want to have a strategy to exercise the options and manage the potential tax liability. 

There is no tax liability in ISOs when the options are exercised, only when the shares are sold. If the shares are held for at least a year after the sale, the gains will qualify for preferential tax treat as long-term capital gains. One issue holders of ISOs could face is the alternative minimum tax (AMT). The spread between the option’s grant price and the purchase price can be subject to the AMT. This is a complex issue and one that you should discuss with a knowledgeable tax or financial advisor. Depending upon your tax situation, it may influence when you exercise the options and sell shares. 

There is no AMT issue with NSOs, but you are taxed on these shares regardless of when you exercise them. Also, once the option is exercised, any gains on the shares will be taxed, either at long-term or short-term capital gains rates depending upon your holding period. 

Place stop orders

If the shares have appreciated and you want to safeguard those gains, you might consider using a stop order for some or all of the shares. A stop order is generally set at a price below the market price on the day you place it. They are generally good for 60 days or until canceled or triggered. 

The stop order triggers a market order if the share price is touched at any point during the trading day. One caution, there is no floor on the execution price. If the price is dropping rapidly, you could be sold out at a level well below the stop price. A stop-limit order sets a floor price below the stop order price below which the shares will not be sold. 

This is not a perfect answer to protecting your gains but can help in some cases. Of course, you will trigger a taxable event in many cases, but paying taxes is generally better than suffering a significant loss. 

Charitable contributions

Assuming the shares have appreciated and are worth more than your cost basis, donating shares to a qualified charitable organization is a good alternative for some or all of the shares, depending upon your situation. If you can itemize, you will receive a charitable deduction for the market value of the shares donated, and you will not be responsible for any capital gains taxes. Donations can be made directly to the organization or to a donor-advised fund that will allow you to allocate money to various charities over time. 

For example, a client of ours recently faced a decision about what to do with a concentrated position in their company shares that arose through the NSOs they were granted. Due to the nature of the company’s business, the shares have boomed in price due to the COVID-19 pandemic. The shares were worth around $2 million. We advised this client to exercise the options to avoid the AMT issues in 2020. We also worked with this client in managing the position to achieve greater portfolio diversification. 

Summary

Concentrated stock is certainly a “nice problem to have,” though it can cause a lot of stress. Making the wrong move can certainly make you even more nervous. The biggest risk you face is if this position is larger than 20% of your liquid net worth. It can subject your portfolio to significant risk if the stock price were to drop significantly.

Managing your concentrated stock position can be a multifaceted issue. Give us a call. We can help you maximize the value of these concentrated positions.

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