Diversify with Confidence – Tailored Solutions for Managing Concentrated Positions

At Mercer Advisors, we’ve worked with many clients who have concentrated stock positions. Sometimes people end up here for emotional reasons – the stock has been in the family for years and they are reluctant to sell it, or they earned it through years of employment and are not ready to part ways. Sometimes the reasons can be logical – their equity position vested after an IPO. In our opinion, these are not sound financial reasons to hold the concentrated position. We will examine the risks associated with concentrated positions, provide solutions to mitigate those risks, and examine the reasons why people are reluctant to diversify.

Risks

The key term here is “idiosyncratic risk,” which is defined as risks that are unique to an individual asset. This is different than “systemic risk,” which is risk that is inherent to the entire market and applies to diversified portfolios. A concentrated stock position is subject to multiple idiosyncratic risks that could have an outsized position on that stock’s performance e.g., company management fails to deliver on projections, a key cost input rises dramatically (e.g., oil for airlines), a major customer switches to a competitor.

In a portfolio with a concentrated position, the fortunes of the overall portfolio are strongly correlated to the performance of an individual stock or asset. For example, say during the pandemic you had a $5M portfolio, 80% of which was in Delta stock, almost overnight that stock declined 63%. Assuming the 20% remained stable in cash, the entire portfolio would be worth $2.4M, or nearly a 50% decline. You would now find yourself in the unenviable position of riding out the recovery (several years on the stock is down 20% from pre-Covid levels) or being forced to sell and “crystalizing” the loss, resulting in permanent impairment of the portfolio.¹

In contrast, individual fluctuations in the value of asset a proportionately lower in a diversified portfolio. A major negative move in one position might still be painful, but the health of that portfolio is not in jeopardy.

Potential Solutions

There are many ways to help mitigate the risks attendant to a concentrated position. Like any other major investment decision, it’s important to talk with an advisor to understand what’s best for you. Some ways we can address the risk include:

1. Gradually sell portions of the concentrated position and implement a tax-loss harvesting strategy to offset the capital gains liabilities.
2. Utilize an exchange fund, which is a vehicle where other individuals with concentrated positions have contributed their assets to in ‘exchange’ for a slice of the overall fund. Over time with enough investors and contributions, this fund begins to behave more like a diversified equity fund, potentially like the S&P 500. There are tradeoffs to this strategy that you should discuss with your advisor, including the fees and lock-up periods.
3. Employ a charitable giving strategy through a donor-advised fund or charitable remainder trust to gift stock directly instead of cash.
4. Gift shares of the position to other family members as part of a holistic estate plan.

Why People Can be Reluctant

In our experience, one reason people may be reluctant to sell portions of a concentrated stock position is the possible tax consequence. The capital gains consequences are often significant, and people think, “Won’t it cost me a lot of money to sell?” Another reason people tend to hold onto their position – they have faith the stock will continue to go up like it has before and they will miss out on future upside. While this may happen, the alternative can be a far bigger cause for concern. Remember, past performance is not indicative of future results. The third reason that people may be reluctant to sell is that they often have emotional connections to the stock – it was a gift, it’s been in the family for a long time, they worked at the company for decades, etc.

Although we can empathize with people who don’t want to diversify a concentrated position, the empirical data is clear that the risk outweighs the reward. Additionally, there is a material opportunity cost if you don’t diversify – by holding onto a concentrated position, you give up the opportunity to invest in other assets that can offer a more attractive potential risk/reward profile. At Mercer Advisors, we understand each situation is unique, so we take the time to understand your situation and create a personalized strategy to help you mitigate your risk and optimize the return profile of your whole portfolio.