Successful strategies to manage your concentrated position

A concentrated position is an investment that makes an outsized share of your total net worth. As a rule of thumb, you should consider any investment that makes up more than 10% of your net worth as a concentrated position.

Why do concentrated positions matter?

Concentrated positions are a great way to build and grow your wealth. Holding shares in successful companies can be highly beneficial to your finances. There are many examples of stocks with phenomenal long-term returns, such as Apple, Tesla, Amazon, Nvidia, etc. Unfortunately, when a single stock makes up a disproportionate share of your portfolio, you expose yourself to unwanted idiosyncratic risks related to that particular investment.

Concentrated positions and risk

What can possibly go wrong with your stock? Well, pretty much everything from changes in consumer sentiments, economic recession, adoption of new technology, bankruptcy (Bath Bad and Beyond), accounting scandals (Enron), bank runs (SVB), management changes, competition threats, pandemic, supply chain disruptions, government policies, and war.

Take, for instance, Kodak and Motorola. Both companies were innovation leaders with great products and consumer brands at their peaks. Kodak invented the digital camera. Motorola had the RAZR phone. Everyone wanted their products until their competitors swept their markets with new gadgets. Technology evolves, and consumer sentiments change rapidly. Some companies drive these changes, others follow, and a third group never catches up.

How do you build a concentrated position?

• You are a corporate executive or an employee who received employee stock options or restricted stock units from your current or previous employer. Through option exercise and RSU vesting, your company shares have grown significantly as part of your portfolio.
• You were an early investor in a startup that successfully went public or a long-term investor in a stock with outsized performance. Your cost basis is low, and your shares have appreciated significantly over the years.
• You inherited or received a significant number of shares from a relative as a gift.

Here are a couple of ideas on how you can manage your risk, earn additional income, and lower your tax impact. Ultimately the best strategy will depend on your individual circumstances.

Risk mitigation strategies for concentrated position

Sell stock and diversify your portfolio 

Diversification is the bread and butter of investing. Building a diversified portfolio that matches your risk tolerance and investment horizon is crucial to wealth preservation and sustainable long-term capital growth.

When a single investment makes up more than 10% of your portfolio, the diversification process becomes more challenging. Furthermore, selling your stocks is not always an easy decision. If you own the stock for long, you probably sit on a significant gain and want to avoid paying taxes. Perhaps you have a sentimental attachment to that company. Lastly, your employer might be imposing trading restrictions on selling your shares.

10b5-1 Plan

A 10b5-1 plan is one that corporate executives and insiders can use to sell company shares under specific parameters like price, time, or other targets, as outlined in the predetermined plan.

Using the 10b5-1 plan forces you to follow a disciplined sales approach to reduce concentrated risk, taking the emotion out of your decisions. You must create your 10b5-1 plan at a time when you have no material non-public information. When your broker executes trades under the plan, you have a justification against any insider trading charges since the plan was put in place when you had no material non-public information.

Direct indexing

Directing indexing is a strategy that mirrors the performance of an index (S&P 500, Russell 1000) by investing in a basket of individual stocks. This strategy can be useful for reducing the risk of concentrated positions over time. Depending on the size and restrictions of your investment, we can incorporate it into the direct indexing strategy. You can determine how much you want to reduce your concentrated position every year until it reaches a more controllable percentage of the portfolio. Furthermore, the tax impact from selling your investment can be paired with tax-loss harvesting and other tax-saving strategies.

Protective put

Buying a put option is a popular hedging strategy. The put option is a contract where the owner has the right but not the obligation to sell a specified stock at a predetermined price on a particular date or during a specified period.

If your stock has appreciated significantly and you have concerns about locking your gains, you can use put options to limit future losses.

For instance, you bought XYZ at $5 per share a few years ago. Now the price is $100 per share. You are concerned about your gains and purchase a put option to sell your shares at $90. By doing that, you keep your upside if the stock continues to rally, but you also secure your gains if the price drops under $90.

The downside of this strategy is that selling appreciated stock can trigger unwanted large taxes because of the realized gains. Furthermore, if your put options expire worthless, you will lose the entire premium you paid.

Tax-saving strategies for concentrated position

Prioritize long-term capital gains

IRS views capital gains in two categories. Short-term capital gains are realized when buying and selling investments for less than one year. These gains are taxable at your ordinary income level.

Long-term capital gains are realized after holding a stock for over a year and one day. These gains are taxable at a favorably lower rate of 0%, 15%, or 20%, plus a 3.8% Medicare surcharge.

You will save the difference between ordinary income tax and the long-term capital gain rate by prioritizing long-term over short-term capital gains. Depending on your tax bracket, the difference between both rates can be up to 20%.

Tax-loss harvesting

Tax loss harvesting is a strategy that entails selling a stock or other investment that has lost value since you bought it. You can use the value of your realized losses to offset other capital gains from other parts of your portfolio in the same tax year.

Furthermore, you can use up to $3,000 annually to offset any ordinary income and carry over any residual amounts for future years.

If you want to purchase your security again, you must follow the wash sale rule. The rule does not allow you to buy back the stock for 30 calendar days.

Donate to charitable organizations

One of the most popular tax-saving strategies is giving appreciated assets directly to charitable organizations. This approach is subject to 30% of AGI for donations given to qualified public charities. Appreciated assets can include publicly traded stocks, restricted stocks, real estate, privately held companies, collectibles, and artwork. The main caveat to receiving the highest tax benefit is to transfer the appreciated asset directly to the charitable organization instead of selling it and gifting the residual cash amount. This way, you will avoid paying a capital gain tax on the sale and deduct the total fair value of your asset.

Set up a charitable trust for your concentrated position

Investors who want to keep some level of control over their charitable contributions can consider several advanced charitable strategies. The three most popular vehicles are utilizing donor-advised funds, charitable remainder trusts, and charitable foundations.

Give a gift to family members

You can gift appreciated stock from your investment account to family members with a lower tax bracket than yours. The gift and estate tax exemption is the amount you can transfer during your life or at your death without incurring gift or estate tax. You can use up to $17,000 a year to give to any number of people without tax consequences. The gift and estate tax exemption is $12.92 million ($25.84 million per married couple, for 2023. The receiver of your gift will inherit the original cost basis.

Stepped-up basis

A stepped-up basis is a strategy to transfer wealth between generations without incurring taxes. Your heirs will receive the appreciated asset in your investment account at a higher stepped-up basis, not at the original purchase price. If stocks are transferred as an inheritance directly (versus being sold and received in cash), they are not subject to taxes on any long-term or short-term capital gains at the date of the inheritance. The stepped-up cost basis transfer is subject to lifetime tax exemption limits.

Income Strategies for concentrated position

Sell call options for extra income

Selling covered calls is a popular strategy for earning additional income on large concentrated positions.

A call is the opposite of a put contract. The call option buyer receives the right but not the obligation to purchase stock at a predetermined price on a particular date or during a specified period. Call options allow investors to bet on increasing prices without buying the stock.

The call seller (you) has an obligation to sell the stock to the buyer if he or she decides to exercise their rights. The buyer pays the seller a premium for entering the contract.

Suppose you believe your concentrated position has limited upside potential. In that case, you can generate extra income by writing call options on all or portion of your shares at a higher level than the current price. If the option expires worthless, you keep your shares and the extra cash. The only downside of this strategy is that if your covered call option is exercised; you must sell your shares at the strike price level and generate a capital gain.

Collar

Often covered call and protective put are combined into a two-step trade called a collar. The combination decreases downside risk. The proceeds from the call sale provide extra cash to finance the premium of the protective put purchase.

Stock lending

Fully Paid Securities Lending is another opportunity to earn extra income from your concentrated position. During this process, the stock owner temporarily lends securities to a financial institution, such as a brokerage firm, bank, or hedge fund. The loan is usually facilitated by an intermediary, the lending agent, or the clearing broker. All parties enter into a loan agreement that covers the terms of the loan, loan fee, revenue sharing, and other provisions.

The main pitfalls of this strategy are the loss of proxy rights and the reclassification of dividends during the loan period. You cannot exercise voting rights. While you receive compensation for any dividends, the extra income will be reclassified for tax purposes.

Prepaid Variable Forwards

A prepaid variable forward (PVF) is a contract to sell a predetermined value of the concentrated position in the future. The number of shares varies depending on the stock price at the maturity of the contract. Specifically, you will have to give more shares if the price at maturity is lower than today’s price and fewer shares if the price is higher than the current price.

The PVF sale may be helpful for investors who wish to create tax-deferred liquidity from a concentrated stock position. Like collars, prepaid forward sales involve the purchase of a put and the sale of a call. The buyer of the PVF usually receives a loan equal to 70% to 90% of the value of the shares.

When a variable contract matures and you deliver your shares, the delivery of the shares will trigger a capital gain. The tax rate on the gain depends on the length of the holding period.

Like any tax strategy, the prepaid variable forward has its own limitations. A few years ago, the billionaire Philip Anschutz lost a lawsuit against IRS for using this technique. He was sentenced to pay $144 million in tax bills.

Take a security-based loan

Securities-based loans enable you to use your concentrated position as collateral to access a revolving line of credit. This strategy allows you to access funds and receive any potential price upside and dividends that accrue in your account without liquidating your concentrated position. However, if you have an outstanding loan balance and your concentrated position declines in value, you may have to post additional collateral or repay all or part of the loan. The lending party may also liquidate all or part of your portfolio to cover losses.