Concentrated stock and employee stock option risk management

Taxable investors have to face the dilemma of when to sell a profitable position and pay taxes on the gain. Paper profits have an intangible, abstract quality to them, but a check to the IRS is for real.  Obviously, if someone knows a stock will decline 20%, selling a stock and paying the tax should be a relatively easy decision. But it’s not. Investors will rationalize that the stock will come back and go higher. They will self-justify “waiting it out” and “in it for the long run.”  Nowhere is this tendency more focused than when the holding represents a large portion of an investor’s net worth and the possible tax bill is an uncomfortable number.

Diversification

My position is rather straight forward. It is always better to diversify a significant concentrated position (be it an individual stock or a large vested in-the-money company stock option position) unless life expectancy is less then four years. However, even when life expectancy is less than four years, it is still prudent to hedge the downside risk of a single concentrated position while awaiting a step up in cost basis.

One potential exception to diversification or hedging would be the case where an investor has charitable intent. Gifting to charity or a charitable remainder trust has the beneficial effect of mitigating taxes and reducing the risk of holding a concentrated position. It’s also possible to obtain an income stream from the gift. However, from a pure economic analysis point-of-view, a charitable gift, even with benefits, is not a profitable investment. Hence the need for a donor’s charitable intent to make this type of strategy feasible. 

The case for diversification is fairly simple math. A single average stock has about 2.5 times the risk of a diversified portfolio. Assume that both the stock and diversified portfolio’s expected returns are 10% a year and capital gains taxes are 20%.  Let’s say the investor has a $1,000,000 position with no cost and will incur $200,000 in tax if he sells. What are the likely outcomes over 20 years? In theory, the $1,000,000 single stock will be expected to grow to $4.5 million after tax when sold in year 20. However, this is not the most likely outcome. Unfortunately, according to research from Frontier Analytics, 43% of the time the investor will end up with less than the $1,000,000 he started with.  There is only a 40% chance the investor will keep pace with a 3.5% inflation rate and end up with $2 million or more after tax. That is volatility working against the investor.

The diversified portfolio strategy greatly increases the odds of success even when starting with the lower amount of $800,000 when taxes are paid. The expected final value on this lower number is $3.8 million after tax, but there is only a 1% chance of finishing below $1 million. There is better than an 80% chance that the investor will finish with $2 million or more after tax.  The odds of keeping up with inflation have doubled and the risk of losing money went down dramatically.

Do Taxes Matter?

Let’s make the analysis from the viewpoint of taxes paid to the IRS.  Even with periods of time shorter than twenty years, the diversified portfolio would need to make 4.6% more for 5 years or 2.3% more for 10 years to overcome the capital gains tax. Given the risk of the average stock (one out six stocks in the Russell 1000 large cap index lost value over six years during the bull market from 1993 to 1999), the average investor is likely to make the extra 4.6% after five years in a diversified portfolio. 

A simple thought experiment will help frame the issue. Assume selling the concentrated position and paying taxes. Which is the more likely scenario to earn back the taxes paid? – the investor buys the same stock back or invests in a diversified portfolio and holds either one for the next five years? Empirically, the diversified portfolio is more likely to get back the taxes paid.  Framed this way, a rational investor would not put all his remaining funds back into the concentrated position.

Investor Psychology

The reasons for keeping a concentrated position have more to do with investor psychology than economic rationality.  Familiarity with the old concentrated stock plus the absolute certainty of taxes to be paid gets contrasted against the uncertainty of return from a new investment strategy. This keeps many investors from taking any action.  Given that this style of “ostrich” investing probably got them to significant net worth, it’s not surprising that investors are reluctant to change what they are (or were not) doing.

Concentrated stock positions tend to be one of the most difficult investments to manage for investors.  Often, it is the single largest source of a client’s net worth. As such, there are large emotional attachments to the position. Despite clear authoritative research that demonstrates the benefits of divesting and diversifying concentrated positions, most investors feel paralyzed to act. Too often, an investor feels that anything done or not done will be needlessly second guessed.

We work with clients to understand their issues around a concentrated position and then design a plan that will move them forward into economic rationality. For those who feel motivated to take action and unwind or hedge their concentrated position on their own, Robert Klosterman, a fellow expert contributor to the Paladin Registry, has written an excellent overview of the various techniques that can be utilized to manage concentrated positions. (See www.paladinregistry.com).  We manage concentrated positions utilizing many of same strategies that Robert outlines. More importantly, we want to analyze the factors that have influenced a client’s decision to hold a concentrated position. It’s only then that we formulate a plan of action to unlock the value from the position and achieve the greater investment efficiencies and safety obtained through owning a diversified portfolio.