Intelligent Design

John McMillen | Portfolio Manager

Learn what matters - and what doesn't - when building a sound investment strategy.

Are Concentrated Stock Positions Worth the Risk?

October 2008

Holders of a concentrated stock position often resist diversification for a variety of reasons, including tax avoidance, over-confidence and emotional attachment.

Though any investor with a highly appreciated stock position will likely face a daunting tax bill, investors must be careful not to let the “tax tail wag the investment dog”. Here are three factors to consider when deciding whether to liquidate a concentrated stock position:

  1. The average stock volatility has increased dramatically in recent years, rising from 24% in 2004 to 36% in 2008. This increased volatility will result in periodic, significant price declines for many stocks. Beyond the worst-case scenarios we have seen this year with the likes of Lehman Bros., Bear Stearns, AIG and others, there is a fairly high probability in today’s market that any individual stock will experience a capital loss in any given year equal to the tax liability at today’s historically low rate.
  2. For investors with time horizons in excess of 10 years, the realized tax burden (the actual cost of the tax liability) can usually be completely recouped. For example, an investor with a concentrated stock position of $10,000,000 and a zero cost basis would pay approximately $2,100,000 in taxes (15% Federal, 6% State). The incremental return needed over and above what is needed had they not sold to recoup the realized tax is shown below:  

The table shows that, even for those investors who are willing to assume the risk of a concentrated position, over long periods there is little if any return advantage compared to a diversified portfolio even after taxes are considered. Given the risk of a diversified portfolio is considerably less than that of a single stock, the risk-adjusted breakeven point is even shorter.

3. Regardless of who wins the White House, the capital gains tax rate is likely to go up, and may be retroactive to 1/1/09 even if the bill is passed later in the year.

Individuals who are fortunate enough to have amassed considerable wealth through a concentrated position often have a strong emotional tie to the stock. Often it has fed, clothed, and housed the family, put kids through school and afforded them – sometimes for generations – a life of privilege.

Today’s investors, however, must realize how much more volatile the market is for individual stocks and consider the very real risk that what once seemed a sure thing could very quickly go up in smoke.

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