Too Much of a Good Thing

To say that I was proud to toe the starting line of the Boston Marathon for the fourth time in April 2024 is an understatement. It represented the culmination of four years of consistent running and high mileage unlike I had ever done in my 20-year “running career.”  There was just one problem waiting around the corner to sneak up and wreck this amazing streak I was on.

Prior to 2020, I included a healthy mix of biking and yoga in my exercise routine. With the onset of the pandemic and the global lockdown, my routine became: get up, go run, shower, go to work (remotely). I no longer went to the gym or met with friends for any diversity in my training routine. Nor did I train for races; all were canceled due to the pandemic. Gone was my speedwork and interval training. Also gone were the injuries I often faced as a result of high-intensity workouts. I became really good at going out almost every day and running five to ten miles.

I ran my first race coming out of the pandemic in late 2021 with a Boston Marathon-qualifying race time. I was stoked! I felt certain this new training regimen was going to be my golden ticket to success from here on out. For the next three years, I continued to train in what I thought was the same manner: high mileage, consistent daily training, one day off per week … and zero cross-training.

It might be easy for athletically inclined readers to foresee the calamity that became my 2024 Boston Marathon. Writing this, it’s easy for me to see. My fourth Boston Marathon ended at mile 11, not even halfway through, when my hamstring gave out and I walked off the course. My first DNF (did not finish).

It’s been a rough three months. Unable to run without serious pain, I’ve been doing everything else that doesn’t cause pain: biking (a lot!), weight training (no lunges!), and yoga—all the things I stopped doing in 2020 while I focused solely on running. In other words, I’ve diversified my training.

I learned my lesson—too much of a good thing is not always a good thing. We can say the same about investing.

How much is too much?

This is a common question investors face, particularly among those who have a significant concentration in a particular stock either from inheritance or as a result of their employment. And sometimes, a large position is simply the result of a savvy one-time investment decision that appears to be paying off. Let’s face it, deciding to trim a big winner is a tough decision and getting the timing right is even tougher! We fear missing out on additional gains by selling too early, even as we worry about holding too long and suffering a loss.

While concentrations may lead to great wealth, the key to maintaining it is diversification. Portfolio manager Ben Rose writes in his article Putting All Your Eggs In One Basket, “A study by Cambridge Associates found that a 75% single stock/25% municipal bond portfolio had a 41% probability to lose at least 25% of its market value in a given five-year period compared to only a 13% probability of that loss in a 75% diversified equity/25% muni bond portfolio.”

Once you’ve decided to reduce your concentration, we recommend creating a decision framework to help you implement a disciplined approach to reducing that concentration. Not only can it feel like a difficult mental hurdle to reduce a position by a significant amount, the decision often has very real tax consequences that should be considered, too.

A Diversification Decision Tree

1. How much of your total balance sheet are you willing to invest in one particular position, sector, or asset class?
   Example: I want my exposure to real estate to be less than 20% of my total balance sheet, excluding my home.
    
   If you have more than one concentrated position, determine how much of your balance sheet you want to allocate to the total of the positions. Then, decide how much exposure you’re willing to hold in a singular position.
   Example: I want no more than 20% of my total balance sheet in concentrated positions. Furthermore, I want no more than 5% of my balance sheet in any one stock.
2. How much capital gain are you willing to realize each year? Establishing a gains threshold will alleviate some of the anxiety about taxes by creating certainty around something that can create an unpleasant surprise each April. Frame this in terms of dollars or a percentage of your total balance sheet.
   Example: I will realize up to $200,000 in capital gains annually.
   —Or—
   I will realize up to 2% of my balance sheet in realized capital gains. (i.e., I have a $20,000,000 balance sheet so will realize up to $400,000 in capital gains annually.)
3. Following these decisions, you can determine how many years it will take you to achieve your desired position size. If your annual capital gains tolerance is high enough for you to reach your target position size “too quickly,” choose a timeframe that works for you. But remember, the goal is diversification, so reducing a position from 50% to 10% over 20 years may not have the impact you’re hoping to achieve. A full market cycle is approximately ten years. Try setting your timeline to less than that. Once you have a target timeframe in mind, divide the total amount of the reduction by the number of years to easily see how much you’ll need to focus on selling each year.
   Example: I need to reduce a position from $5,000,000 to $1,000,000 and would like to reach that goal in five years. I will need to sell $800,000 worth each year.

Taxes matter. A lot.

One of the biggest obstacles to diversifying is taxes. Why take a tax hit by selling when it’s not necessary? After all, realizing a capital gain that results in taxes is a voluntary decision. You only pay the tax when you decide to sell the stock. However, selling the stock may make sense for risk management reasons or because better investment opportunities are available. While taxes can be a drag, they can be made up over time and should not be the ultimate driver when considering diversification.

If paying taxes just isn’t your cup of tea, there are ways to defer or eliminate them. Gifting the stock to a donor-advised fund (DAF), an exchange fund, or a charitable remainder unitrust (CRUT) are all effective strategies to help eliminate, spread out, or defer taxes. The choice of strategy will depend on your goals and objectives.

CRTs and DAFs

Charitably inclined investors may be drawn to the idea of gifting appreciated stock directly to a public, non-profit organization. A donor-advised fund may be appropriate if an investor does not have a specific organization in mind at the time of diversification. You can read more about the benefits of using donor-advised funds in this article by client advisor George Climer.

A charitable remainder trust (CRT) is another option that allows investors to receive a charitable deduction upon funding; it also provides the noncharitable beneficiary with an annual income stream for the term of the trust. Capital gains realized in the trust are passed over time to its noncharitable beneficiaries as they receive the annual distributions. This strategy represents a way for taxpayers to spread out the impact of capital gains over time while still achieving diversification by removing the asset from their balance sheet.

Exchange Funds

Investors looking to swap their single stock exposure for a tax-managed diversified fund while deferring capital gains recognition may find that exchange funds offer a unique alternative. An exchange fund is a privately placed investment vehicle that allows investors to contribute their concentrated stock positions and, in return, receive shares in the partnership. The price of these shares fluctuates daily based on the value of the fund’s holdings. The contributed shares’ original cost basis is transferred to the fund in exchange for diversified units, and any embedded capital gains taxes are deferred while the asset remains in the exchange fund. This allows for immediate diversification without incurring tax costs while still allowing for a step-up in cost basis at the shareowner’s death.

Exchange funds require a seven-year holding period. If an investor wants to sell the equity earlier, they may face fees and additional taxes—and they will typically receive the lesser of the value of the original stock or the fund shares. After seven years, an investor can exit instead with an assortment of diversified securities. The original cost basis of the concentrated position carries through, regardless of when the investor exits the fund.

These funds are ideal for investors with concentrated single stock positions held at a significant gain who want to diversify their risk while kicking the tax can down the road. While these funds typically provide either daily or monthly liquidity for redemptions, they often enforce a 1% penalty for early withdrawals, making them a poor solution for investors looking to increase the liquidity in their balance sheet in the near term. Some funds may also impose liquidity constraints on profits beyond how the contributed stock performs. Finally, many of these funds charge an upfront sales charge as well as ongoing investment management fees that may range from 0.8% to 2.0% of the portfolio value annually.

Hedging

As Ben Rose notes, “There are several ways to hedge a concentrated position. Hedging can be costly, and you still retain the concentrated position. We rarely suggest hedging, though it may make sense if a step-up in cost basis was imminent, and you could wait until the shares were bequeathed to heirs to sell or trim the stock.”

The Little Things

Don’t neglect the power of small changes in addition to these larger strategies. In any year you’re realizing more capital gains than usual, work closely with your portfolio manager to tax-loss harvest other positions as you pare down the concentrated position.

If you’re already making annual exclusion gifts, consider the income tax rate of the individual recipients. It may make sense for you to gift appreciated stock to someone in a lower capital gains tax bracket. You are limited to the annual exclusion amount each year and you may only have limited capital losses to harvest but, as client advisor Lynn Araujo states in Simple Solutions to Reduce Your Estate Tax, since these “low-hanging fruit” options sound simple, we find it’s easy to underestimate their value over time.

Hindsight is Always 20/20

Back on the subject of my marathon training, I can see points during the last few years when my body began to react differently to the training I was making it endure. Had I taken steps along the way to diversify my training, I think it’s safe to say that I would still be running right now.

Likewise, rather than waiting until your “pet stock” is on a downward spiral, potentially leaving you with a greatly reduced balance sheet and serious regrets, we recommend you implement a disciplined diversification plan early. By carefully considering risk tolerance, tax implications, and investment goals, you can select strategies best suited to your circumstances. You may find that implementing several options for diversification is right for you.

It’s also important to regularly review and adjust the strategy to ensure it remains aligned with changing circumstances and goals. Ultimately, with a well-executed strategy, investors can ensure that their concentrated stock positions don’t become too much to handle, and instead, lead to a successful and prosperous outcome. Let us know if we can answer any questions you have about managing concentrated positions in your portfolio.

This information is believed to be accurate at the time of publication but should not be used as specific investment or tax advice as opinions and legislation are subject to change. You should always consult your tax professional or other advisors before acting on the ideas presented here.