A common rule of thumb says that 15-20% in one investment is a large or concentrated position. The problem with this rule of thumb is that it’s a generalized idea that doesn’t apply to everyone. Large stock positions can be the quickest way to wealth creation and the quickest way to wealth destruction. This begs the importance of planning around large positions to create wealth and limit the chance of wealth destruction.
For recipients of equity compensation, it’s common to have a large position in one company. Typically this is in the form of restricted stock, restricted stock units (RSUs), employee stock purchase plans (ESPP), and stock options. You might also have a large position from an inheritance or an investment performing very well. Regardless of how you acquire a large position, creating a strategy to align it to your goals becomes very important.
The first thing to determine with large stock positions is how much is too much. Remember the 15-20% rule of thumb? That may or may not apply to you. To determine this, consider other assets and your goals. A question to ask is, if your large stock position went to $0.00, how would it impact your goals or financial future?
For example, let’s say a stock position was 10% of your portfolio when it was acquired. Then, it went on a great run and now makes up 50% of your investment portfolio. As a rule of thumb, this is highly concentrated. But what about the other 50% of your invested assets? Can the other half of your investible assets make work optional or allow you to live a financially secure life? If so, then a 50% position in one stock might be ok.
For many people, a 15-20% allocation in one stock position could negatively affect their financial well-being if it performed poorly. For this reason, planning around large stock positions becomes important. If you are looking to reduce the risk of a position becoming a financial burden, let’s cover some strategies.
This is the most straightforward way to reduce large stock positions. When creating a selling strategy, consider your tax exposure if the stock is in a taxable account. Shares held more than a year enjoy long-term capital gains rates. Shares held less than a year are taxed at ordinary income. If the shares are held in a tax-deferred account, such as a 401k, there won’t be a capital gains tax when selling. However, in a 401k, you could have opportunities such as net unrealized appreciation, which we will discuss shortly.
If the shares do not have restrictions, the first step is to create a share reduction strategy. Determine the number of shares to sell at predetermined dates to reduce the position slowly. If selling creates a taxable event, determine where you’ll fall within the capital gains tax rate and which shares can minimize tax. The goal is to reduce the position, maintain wealth, and reduce the bill to Uncle Sam. Then, carefully navigate your capital gains rate if there is an opportunity to recognize gains at lower rates. For example, in a year with less income, you could sell more shares and be subject to less tax.
If you have an emotional attachment to a stock, it becomes more important to have a proactive plan. Planning will reduce human emotion rather than attempting to decide when you need to sell. One way to accomplish this is to set a predetermined price or date.
Selling shares in increments is the most simplistic way to reduce a large position. However, selling is not the easiest from a human behavior standpoint if you have created most of your wealth with one company. Seek out a financial professional who can help you create a proactive plan if you need guidance.
Options can protect large stock positions in the form of a hedge or as a stock reduction strategy. These are complex financial instruments, so be sure to seek a financial professional with a background in options. Options aren’t available for every stock. For publicly traded companies, they are generally available. Options are not able to be placed in a 401k or workplace plan. You can, however, execute option strategies in a standard brokerage account or tax-advantaged account such as an IRA. You will typically need to be approved for options trading by your brokerage firm.
Protective Put. Buying a put option is simply like buying insurance on your stock position. It gives you the right to sell some or all the stock at the put option price (strike price). If the stock price is below the put option strike price on expiration, you have the right to sell your stock at the strike price. If the stock price goes up, participate in the stock appreciation and only lose what it cost to purchase the put option. The further the put option is from the actual market price of the stock, the less expensive it will be. This allows you to set a price floor on the stock. A protective put serves as a hedge and can lock in a price to reduce a stock position.
Selling Call Options. Selling call options doesn’t provide quite the downside protection as buying a protective put. However, it does allow you to create income while potentially selling the shares at a higher price. Selling a call option gives you the obligation to sell shares at the strike price or the price you sell the call option. In exchange for limiting your upside potential, you receive a premium as income against your shares (The premium is the amount you receive for selling an option). If the stock is above the strike price at expiration, you sell shares at that price and keep the premium. With this strategy, you are protected on the downside by the amount of the premium.
A Collar Strategy. This is the combination of the two strategies above. For example, buying a put option while selling a call option does two things — it protects your downside and limits your upside. If the stock moves big in one direction, you potentially sell the stock at the call’s strike price or put. This allows you to set an upside and downside limit on your stock.
Depending on the strike prices of the collar, it can be set up to where you receive a premium (if the call option is sold for more than the put is purchased for) or a net-zero transaction (where the premium from selling the call is used to buy the put option). A net-zero transaction is known as a cashless collar. Meaning, the put option cost is the same as the premium received from selling the call option. As a result, both options would be in the same expiration cycle.
Something to be aware of with options is the tax implications on the sale of stock and gain/loss on the options.
Net unrealized appreciation is a strategy that utilizes company shares inside of a 401k plan. NUA allows investors to take company shares with a low-cost basis out of a 401k and pay ordinary income tax on the basis only. The stock is transferred out of a 401k to a taxable account where the unrealized appreciation (the difference between the basis and current price) is taxed at long-term capital gains when sold. As a reminder, distributions from a 401k are taxable at ordinary income rates. Thus, NUA allows the distribution of company stock to enjoy lower tax rates potentially.
NUA does have a few rules to be aware of before you consider this strategy. First, read this detailed blog post on a net unrealized appreciation that explains how it works and if it makes sense for you.
Large stock positions can be challenging to diversify. You may have seen your company stock explode over the years or witnessed it crumble. The thing is, nobody has a crystal ball. You have to determine when enough is enough for you to do the things your money is working towards.
The ability to properly diversify and manage risk is part of the wealth-building process. But, remember, the same strategy that creates wealth isn’t the same strategy to keep wealth.
These strategies above can reduce your risk, potentially lower your tax burden, and keep your money on track to reach your goals. If a stock position is consuming a big portion of your investible assets, we are here to help you build a strategy that continues to build wealth and reduce risk.
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