In the blog post prior to this, we shed light on why individual stock selection is not a particularly good investing strategy; however, as humans, we all make mistakes, and what if, unfortunately, you already own a decent amount of individual stocks?
In the following blog, we will work our way around what individual stock concentration means, how it isn’t good for you, and how you can take steps to minimize stock concentration in your portfolio.
Effect of Owning too many Individual Stocks
If you hold a significantly large number of shares of stocks of a single company, it can make your portfolio concentrated. A lot of people who have worked for a company for an extended period, including executives, often end up holding a concentrated stock holding in one company, normally their employer. This can become difficult for the investor in terms of less diversification, liquidity, and tax issues. A largely concentrated stock position makes the investor vulnerable to a significant risk to one company’s profits. Moreover, if there have been major capital gains accrued on the position, selling the whole position might not be a tax-saving option.
How much is too much of one Stock
As a general rule of thumb, when one stock is more than 10% of your investments, it becomes a concentrated stock position, and the red flag goes up. There may be numerous reasons for a concentrated stock position. Some can’t sell their company stock cause of employer restrictions. Others might not be willing to pay the income tax on the profit. Some might be thinking the stock may still go higher.
Why is there a need to reduce this concentration?
Some relatively useless stocks might take up space that could otherwise be used productively when your portfolio gets concentrated. Staying with one investment may hinder you from taking a chance with a newer, more promising investment that could get you to your financial goals faster. Concentrated portfolios can prove to be a lot riskier, as it isn’t logical to bet all your fortune on one particular company. What if you chose the wrong company and its competitors had more profits? This is why concentrated stocks need to be diluted.
How you can dilute concentrated individual stocks
Now let’s move towards the main reason for writing this blog, ways to make your portfolio less concentrated. In the following passage, I will include a detailed list of ideas you can use to dilute your portfolio.
- Structured Stock Selling
One of the options is to sell the stock or a portion of the stock upfront. Long-term profits are when an investment is kept for at least a year. Any investment sold for a gain and held less than one year is considered income for tax purposes and is taxed at greater ordinary income tax rates. But long-term investment gains taxes can be as much as 23.8% for Federal taxes, and any state taxes will be in on top of that.
One way to lessen the tax burden is to sell a fixed value of the stock over time, for example, every quarter. The time frame can differ. A 3-5-year time frame normally works perfectly fine for most investors. However, the aim is to make notable progress in reducing the position. After all, reducing exposure is the main objective.
However, there are some chances opportunities might become available to sell a larger amount. For instance, if there is a year when income is less due to reduced bonuses or being between jobs, it could be an opportunity to sell stock and bear less of a tax bite. Nobody wishes to make less than their usual pay, but if it does happen to you, you should take full advantage of it. Leads from the stock sale can also aid in the shortfall in income if needed.
Scheduled selling of stock may need to happen for executives that the company still employs. The stocks might need approval for them to be sold.
- Gifting Stocks
1. Direct Gift of Stock
Gifting is a useful strategy to dilute your portfolio. A common choice is to gift stock straight to non-profit charities. This way, you can reduce your stock position without any taxes being applied. You benefit by reducing your position and the charity benefits by selling the stock without paying any taxes as it is a non-profit organization
2. Donor-Advised Funds
Donor-advised funds are a flexible way of gifting. An investor can fund the DAF with stock, and possibly, the investor will get his/her tax equivalent to the value of the stock at the time of funding. The stock is sold, and its profits are dumped in investment pools that the investor will control. The investor can choose from bonds, money markets, and diversified pools of stocks, which gives the account potential to expand. When investors want, they direct the DAF to liquidate funds from the investment pools to charities of their choice.
3. Charitable Gift Annuities
A charitable gift annuity might be a good option for someone who requires income. The charity takes the donated stock and forms an annuity income stream for the donor using the returns. The investor receives a partial tax deduction plus income for life. When the donor dies, the charity gets hold of the remaining funds.
4. Charitable Trusts
Trusts are a little more complex but can be structured with a range of gifting techniques and can be funded with appreciated stock. The trusts open up opportunities for gifting while offering tax reductions and can also be a source of income for the donor. The investor can get a tax deduction along with annual income and name a charity to receive the remaining funds in the future. The opposite type of trust is a Charitable Lead Trust (CLT). With a CLT, the charity ‘leads off’ by receiving annual income for a decided period, and the remainder goes back to the trust or family. There are many other types of charitable trusts, and appreciated stock could fund most of them.
5. Gifting Stock to Family
Gifting stock to your family, close relatives, or children is a common gifting technique. This works if the children are now adults and the stock investor is currently providing them financial aid. Examples include helping children with a down payment on a new house, getting a car, or sponsoring a trip abroad. The kids can then sell the stock and use the income that comes from it. Since the kids will mostly be in a much lower tax stature, capital gains taxes may be lower or eliminated.
- Exchange Funds
Exchange Funds are private placement limited partnerships or LLCs. This method allows an investor to ‘exchange’ an individual stock for shares in a pooled fund of more than one stock. The funds are structured in such a way, so the stocks are from different industries and sectors to provide immediate diversification. If your initial stock decreases in value, you hold the value of the diversified fund. Choosing an Exchange Fund also allows the original value of the stock to be invested without first paying taxes, selling, then investing the remainder.
There are key limitations to utilizing Exchange Funds. The individual must be a Qualified Purchaser, defined as having $5M in investable assets. And there are lock-up periods of at least seven years, potential loss of dividends, fund management fees, and other considerations. Also, if the original stock exchanged outperforms the fund, the investor is stuck with the fund value. Moreover, the investor still holds the initial cost basis of the stock with the new fund position, though the need to sell is not as much as before due to diversification. Still, Exchange Funds can be a suitable option for diluting a concentrated stock position for qualifying investors.
- Using a trust when selling stock
Supporting a trust with a low basis stock and using a situs in a low tax state can decrease capital gains taxes when selling securities. This is because the profits are subject to the situs state’s law and tax laws. This is correct, whether the trust was formed with the state as situs or as an old trust that fluctuates situs to a different state.
Many high tax states have long-term capital gain tax rates of 5% or greater. If owners are selling notable positions of low-cost basis stock, the tax percentage can be big. Using trusts with situs in positive tax states can decrease or altogether eliminate the state tax bite. Federal taxes are usually not affected by the trust situs, but savings on state taxes can still be important and useful.
Using a trust for selling stock mostly works better for bigger positions of a few million dollars or more. This is because the savings are required to offset legal and administrative fees. However, for positions large enough, the discount in taxes can outweigh the extra costs quite easily.
Trust laws can be difficult to understand, and the investor might end up losing full access to the stock depending on the trust language and state laws. If you are considering using a trust for selling shares, it is vital to work with professionals. Find an attorney and trust company that knows its way around trust situs, regulations, and state tax and estate tax laws.
- Using covered call options
A covered call means a financial transaction in which the investor selling call options owns acorresponding value of the underlying security. To make this possible, an investor holding a long position in an asset then writes call options on that same asset to produce an income influx. The investor’s long position in the asset is the ‘cover’ because the seller can distribute the shares if the buyer of the call option opts to exercise.
A covered call assists as a short-term
hedge on a long stock position and enables investors to make income through the
premium they get for writing or selling the option. But, the investor withdraws
stock gains if the price shifts above the option’s strike price.
As explained in our previous blog post, individual stock selection is not exactly worth your time and money. Concentrating your portfolio with individual stocks is the worst position for an investor. Hence, we suggest you immediately start diluting your investments, with the help of this detailed blog post, of course. Once you diversify your portfolio, guaranteed, risk-free and high amount of returns will surely come your way. In simple words, diversification and long term planning is the key to any form of investing.
September 03, 2021