Wise Wealth Management

Dennis Covington | Principal

Insights on the keys to enjoying a "healthy wealth".

Why Concentrated Stock Positions Make Planning Pointless

August 2010

One of the key components of Comprehensive Wealth Management is to run scenarios using different variables to make sure we are addressing different possible outcomes for our clients. For instance, do you want to retire at 58 or 65? Do you want to take Social Security early, or defer to later? Do you spend 2% of your portfolio a year or 12%? (You won’t have a portfolio for long if you take out 12%, by the way.) 

These variables, and many more, are all important to the planning process, which is why we often use complex modeling software to run thousands of different simulations. We need to look at probabilities of success in order to help our clients develop a meaningful wealth management plan.

Yet, for many investors, there is often one variable that supersedes all others, a huge “X” factor that will be far more important to the investor’s financial future than all other factors combined: 

A large concentration in a single stock. 

Think about it: We can run all kinds of simulations addressing all different manner of variables, but if an investor has nearly all of their net worth tied to a single stock – then the other assumptions don’t matter much. The investor’s financial fate is going to be attributable to the fate of that one company. If it swims, the investor swims with it. If it sinks, so sinks the investor. 

Let’s go back to 1999 and imagine I worked with an executive of, say, Delta Air Lines. She has a high net worth, but it is all in Delta stock, which she has amassed through years of stock options and by investing in company stock in her 401(k) plan. Thanks to her loyalty to her company, she has watched her net worth grow from less than $100,000 to over $2 million in just a decade. 

She wants me to do planning for her. But when I tell her the most important part of the plan is for her to diversify her concentration in Delta stock, she balks. After all, Delta stock has been very good to her these past 10 years. The whole reason she is even talking to me, in her mind, is because of the success of good old DAL. Why would she be disloyal to the very stock that has gotten her where she is today and pay a 20% capital gains tax on it to boot? 

With the benefit of hindsight, we know how this story ends. From 1999 through 2007, Delta is on a slow death march to bankruptcy, and this hypothetical executive watches her net worth march downward with it. Her new stock options are all underwater and she no longer buys company stock in her 401(k), but she continues to cling to her existing positions in Delta stock, sure that it will bounce back. But she is wrong: by the time Delta files for bankruptcy, she is out of a job and out of money in her investment portfolio. 

It is blatantly obvious to us that the Delta executive is nothing short of foolish to not diversify her stock position and pay the taxes, but it sure isn’t obvious in real time, because not all stories end badly. Sometimes investors make a tremendous amount of money by holding on to a particular stock. The problem is we don’t know which company is going to be a homerun and which company is going to be a strikeout. Many times companies can hum along for years and then suddenly hit an unexpected turn in the road that tanks their stock. A few recent examples: Blockbuster, Toyota and pretty much any financial stock in 2008. 

Most investors don’t start out with the intent of owning a huge block of concentrated stock – it just happens, either through inheritance, employment, or by selling your company and taking stock in the transaction. It can be hard to pull the trigger not knowing if you have a winner on your hands, but that’s not really the point. 

The point is, you are playing a glorified game of roulette when you let your financial future ride on the fate of a single stock. And that’s no way to plan for a healthy wealth.

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