Single stock concentration can be an effective vehicle for wealth creation, but diversification is often the key to preservation.
Your equity-linked compensation is likely the cornerstone of your wealth. Yet remaining concentrated in a single-stock holding period can expose you to significant uncompensated risk. It is unlikely that other aspects of your personal and professional life are dependent on one component, so you understand the wisdom and prudence of diversification. But as a corporate executive there are challenges that may prevent you from divesting your company stock. These include:
- Regulatory constraints and corporate trading policies that prohibit you from selling due to corporate insider status
- Loyalty to your company and concern that selling stock may raise concerns among shareholders, your board and the market that something is awry or you lack confidence in your company
- Low cost basis in highly appreciated stock, which requires you to grapple with capital gain tax considerations
Risk of Concentration
It is not easy to simultaneously balance strategies to sell in light of applicable restrictions, loyalty to your company and a potentially large tax bill. Additionally, you may desire to hold your company stock long-term to realize a superior rate of return. But the relationship between portfolio risk and diversification is well-documented. In a recent paper, for example, we demonstrated that a median individual stock that was a constituent of the Russell 3000 index between 1999 and 2018 exhibited more than three times the volatility of the overall index during the same time period. For more insight regarding the risk of concentrated positions, read The Risk of Holding Concentrated Stock.1
The Relationship Between Stock Concentration and Portfolio Risk
Individual stocks have significant idiosyncratic risk, which is the unique firm-level risk that is not explained by the systematic risk of the overall stock market.
Northern Trust’s Goals Driven Wealth Management framework is a valuable tool to bring clarity to your reliance on concentration, determine the risk it poses to meeting your goals, and form a diversification strategy. By building a picture of your assets, quantifying goals, and aligning them to assets, clarity emerges regarding what is needed to fund and continuously optimize a lifetime of evolving goals. For more on building a personalized wealth plan to meet challenges with confidence, visit Goals Driven Wealth Management.
Strategies for Diversification
In light of regulations, corporate policies and concerns over real and perceived impact on company share price, diversification can be a substantial hurdle for corporate executives. Yet there are steps you can take to divest company stock and reduce concentration risk. Below are examples of several strategies that can help corporate executives achieve greater diversification.
Note that as with all strategies involving company shares owned by you as a corporate executive, you will need to confirm whether any given strategy is permitted by your company.
Execute a rule 10b5-1 stock sale
As a corporate executive, you face significant restrictions on your ability to sell your company stock. A Rule 10b5-1 Plan, approved by your company and executed in accordance with SEC law, can provide flexibility in divesting your concentrated position. Consider incorporating this strategy to pre-plan transactions and avoid sending mixed messaging to the public when you sell a significant tranche of stock.
Satisfy charitable giving goals
Based on your philanthropic goals and income needs, it may be equally rewarding and beneficial to contribute low basis stock to a public charity, donor advised fund, private foundation or charitable remainder trust. The tax rules have many nuances, but with proper planning you may benefit from a charitable income tax deduction up to the full fair market value of the stock and either eliminate capital gain tax on the sale of appreciated stock or, in the case of a contribution to a charitable remainder trust, defer capital gains tax.
Swap concentrated stock for a pool of stock
An exchange fund may be an option in some circumstances. This is a private placement limited partnership or limited liability company that allows an investor to exchange their stock for units in the entire fund’s portfolio. The fund is made up of a pool of stock from different sectors and industries owned by other concentrated shareholders. If the value of your stock declines, the impact to you is diminished since you hold units of the diversified fund. As with all of the strategies discussed, each situation is highly specific relative to planning as well as regulatory and contractual restrictions. You will need to work with your advisors to determine what is likely to be effective and permissible.