We frequently encounter portfolios with concentrated stock positions where the investor is reluctant to sell to diversify the portfolio. Reasons given for the reluctance include not wanting to pay capital gains tax or an emotional or family attachment to the stock. Concentrated positions, particularly in retirement portfolios, create risk due to a lack of diversification. Lack of diversification is a leading cause of failure (running out of money) in retirement portfolios. Ask anyone who had concentrated positions in Enron, Lehman Brothers, or any one of hundreds of other recent stock disasters in their retirement portfolios.
For us, as fiduciaries, the decision to sell and reinvest concentrated positions is driven by our duty to diversify client portfolios to protect them from unnecessary losses. It usually is not justifiable from a risk standpoint to maintain concentrated positions in a portfolio, especially one that must deliver income. Tax considerations are important but not as important as risk-based considerations because the consequences of risk decisions are much higher. The crux of the problem is that investment losses occur on the entire principal amount of an investment, while only the gain is taxed.
As an example, let’s look at an investor, age 65 with a $100,000 portfolio with a position in one stock that occupies 30% of the portfolio, or $30,000. Should the company experience difficulties and the stock drop 50% (a not uncommon occurrence in today’s volatile market) then the value of the portfolio is reduced to $85,000. The soon- to- be retiree needs to withdraw $9,600 per year from the portfolio. At the historical rate of return of 7.6% for a balanced portfolio (60% Stocks, 40% bonds) the funds in the portfolio would be expected to last 21 years or until the investors age 87. If the 50% loss in the concentrated stock position occurs, the funds would only last 16 years or to age 81, a significant reduction.
If however, the investor sold the concentrated position and paid the tax on the gain the portfolio would only be reduced by the tax on the gain of $15,000. At 15% this amounts to $2,250. The funds in the portfolio would still be expected to last 21 years to age 86 and, assuming the proceeds were adequately diversified without altering the basic 60% stock, 40% bond structure, the portfolio would be much more stable without the concentrated position. Note that a higher bracket taxpayer paying a 20% capital gain rate would still benefit as the higher tax would still only reduce the amount of time that the funds would last to 20 years from 22.
Much the same logic can be applied to emotional attachments to stocks. We often are asked by clients to “not touch” a concentrated position in a portfolio when we begin managing it because the stock was inherited or has some other emotional significance to the client. Again, when the risks to the overall goals of the portfolio are considered, it is almost never appropriate to maintain the concentrated position.
Sometimes the development of concentrated positions is unavoidable, for instance, with executives of publicly traded companies whose compensation is paid largely in company stock or options on company stock. But for most investors the best way to avoid disaster during the accumulation phase of retirement saving or failure during the payout phase is to not allow concentrated positions to develop. Limit positions in any given company to no more than 5% of a portfolio. Note that mutual funds, in general, are a great way to provide considerable diversification at a reasonable cost.
Should you find yourself in this position, however, we recommend that that you consider biting the bullet, paying the tax and cutting the cord on the highly concentrated position in your retirement portfolio. Always consult your tax and investment professionals before taking any investment action.