Well, we have seen the market give up quite a bit of gains this year. Maybe after the last decade plus of great years we forgot the market can go down. Who knows if we will end the year negative, but right now things are looking good for those accumulating assets as opposed to those in retirement or nearing retirement who may want their investments to never go down. Regardless, I want to spend a few minutes talking about something I deal with a lot. Concentration risk. And the emphasis will be ways to reduce your concentration risk for cases like now – down markets.
As always, let’s begin at the beginning. We need to define what exactly is concentration risk. The simplest definition is it is the amount of risk you are taking by investing in one stock. This is common in the world of equity compensation.
You start out by participating in your Employee Stock Purchase Plan through payroll deduction. Maybe you also are awarded some Restricted Stock, Restricted Stock Units and/or Nonqualified Stock Options. This all starts off harmlessly. However, over time the amount of company stock you are accumulating becomes a larger and larger part of your overall net worth. And when I say net worth I am really talking about your investments besides your house. I mean, you always have to live somewhere, right.
Again, what I see happen time and time again is your concentration risk gets larger and larger because you not only acquire more shares but also the value of the shares starts increasing…hopefully.
Please don’t hear me wrong. This is a great problem to have. You have more shares of a stock that is doing well. However, stocks don’t always just move up. This is what we see now. And, as you get closer to retirement maybe you don’t want to take as much risk of your net worth dropping substantially due to a drop in the value of your concentrated stock position. In those cases, it may make sense to start reducing your concentration risk to a more tolerable level. So, let’s talk some tips.
The one question that is recommended in the world of answering what is the right amount of concentration risk is the old – How much of this stock would you own if you weren’t employed by them? This is a great question, but also a bad one. It is hard to answer this question fully as I don’t know anyone who can completely separate themselves from the scenario I mentioned earlier where the company stock you own has done exceptionally well over the years. Odds are there are lots of other factors coming into play and all related to why you have worked there for years and year and years. My point is – for now let’s just forget about answering this question. Instead, let’s talk actionable items.
I am not going in any specific order here with my tips. Ultimately, you need to develop an overall plan with your CFP who specializes in equity compensation. There are lots of things to consider, like time to retirement, overall concentrated risk position, income needs, taxes, longevity, charitable giving, and more. It is not a simple thing to execute effectively and is the reason I advocate working with a CFP who caters to this world.
Your first tip involves stop losses. Specifically, I want to talk about stop limit orders. These are orders you put in to sell or buy a stock once a certain price is hit. Here we are going to focus on selling a stock. There are two parts here. Once the stock price hits a stop price and then the limit price. I’m trying to be careful here to not get too technical and will stick with a simple explanation. Say your company stock is worth $100 a share and you have the ability to sell it. You decide you want to sell if it drops by 20%. So, you set up a stop order with your CFP so if the stock gets down to $80 it may sell. Now, in my opinion you will want to add a limit to this stop order. This means it may sell once it hits $80, but only at a certain price point. If you went with just a stop order the order to sell would be triggered once the stock drops to $80 and then at whatever the next market price is. So, if you stock drops quickly for some reason and goes from $80 down to $70 and then back up to $80, well a simple stop order would result in your stock selling at $70. With a stop limit you could set it up so the stop order goes into effect at $80 and then the limit is you will not sell at any price below $80. Based on the previous example, the stop order is triggered once it hits $80, but does not sell at the next price point of $70. Instead, as the stock rises back up to $80 your limit order now sells. Again, the stop limit helps you to sell the stock as it drops in price but you can limit how much of a loss you are willing to incur.
Your next tip is to look at charitable giving. Another simple example here. You do regular charitable giving. Maybe you tithe to your church or give to your alma mater every year. Odds are you just write a check out of your bank account. Makes total sense. However, what if you were to donate some of your company stock to any of these charities? You would achieve many goals and potentially reduce your tax burden too. Most charities are set up to receive stock. The basic way this works is you take some highly appreciated stock and send it over via a donation to the charity. You fulfill your charitable donation goal for the year and you get to use some of the donation to reduce your taxes. I recommend doing this with stock that is appreciated. Otherwise, you sell it and recognize the gains when you go to file taxes. By donating the appreciated stock you may get a tax deduction and the charity can then sell the stock. Also, if you have company stock that is down in price, well, you want to hold onto those and sell them yourself. This way you get to use the losses to reduce your taxes too. So, regularly donating appreciated company stock to charities is a good way to reduce your concentration risk. And if the stock is down in price, you can sell it yourself, harvest the losses and use the proceeds to still make the donation. As a bonus, you may want to consider something like setting up a Donor Advised Fund for those times when it may make sense to do bigger donations. Again, something to talk over with your CFP.
This next tip gets a bit more complex to execute. It has to deal with bracketology, but not the basketball kind. Here I am talking about filling up tax brackets. Again, simple explanation. Let’s say your income is $300,000 a year and you fall in the 24% federal tax bracket. You want to reduce your highly concentrated stock position but would rather not tip Uncle Sam. You know, pay out too much in taxes. With knowing your tax bracket and doing some tax planning you may be able to sell some of concentrated stock and staying within the 24% bracket and not jump into the next bracket, which is 32%. The 32% bracket starts just over $340,000 of taxable income. I mentioned this one is more complex. It is. You need your CFP and probably your CPA on this one. Some concentrated stock may be considered ordinary income and some long-term capital gains. It is important to know this information to effectively execute this concentrated risk reduction strategy. And, do NOT wait until the end of the year. It is too late to do effective tax planning the week of Christmas.
Here is probably the simplest tip to reduce your concentrated risk position. If you are participating in your ESPP plan, stop. I know, it hurts. ESPPs typically allow you to buy company stock at a reduced price. Maybe even 15% off. However, this is the quickest way to slow down how much you are adding to the company stock you hold. You can’t stop when the company awards RSUs to you, but you can stop buying more through ESPP.
A slightly opposite strategy from the stop limit sale where we talked about selling company stock as it drops in price is to sell company stock as it goes up in price. Again, you can use stop limit orders to do this. I won’t go through the concept because it is basically the same as the downside limits, but as the stop moves up. This is an effective strategy when you say you don’t want your overall concentration risk to get above a certain percentage. Or maybe you just say when your stock hits a certain price per share value you decide to take some of your winnings off the table. I don’t like using gambling terms, but it is the best one I can think of. Again, be cautious of taxes with this strategy.
The last tip I want to share is to be aware of the big picture. Maybe I should say to be considerate of the forest for the trees. Here I mean to know not only your concentrated stock position but also your overall portfolio. Let’s assume your concentrated risk position is 50% of your overall net worth. This most likely means your overall asset allocation of your investment portfolio is at least 50% in equities/stocks. Now, what does the other half of your net worth look like? Again, I take out the value of your house for most clients as you always have to live somewhere. Let’s look at a simple example. Your overall net worth or investable assets is $4 million. If half of this is in one stock we already know you are at least 50% in stocks. The non-company stock portion of the portfolio is $2 million and maybe you have the traditional 60/40 portfolio. This means 60% in stocks and the rest in bonds and cash. Well, once you pull back in the $2 million in company stock your overall portfolio is actually 80% in stocks and the rest in bonds and cash. So much for that 60/40 allocation you were shooting for. Maybe you can’t reduce down your concentrated stock position down for whatever reasons. Well, a good tip to mitigate a pullback in the market in these situations is to at least better balance the overall portfolio by paying attention to the non-concentrated stock position. Again, you need to look at both the forest and trees in this situation.
This seems like a good place to stop. Hopefully you find this helpful. Having a plan to reduce the concentrated risk you may be dealing with is key, especially as I see some local stocks down more than 25% from recent highs. I would hate to explain to a client who is getting ready to retire from one of those publicly traded companies their retirement plans are on hold because we didn’t address the concentrated risk positions. Again, this is a complex strategy to execute properly. There are lots of moving parts and why I advocate for working with a CFP who caters to the world of equity compensation. Although I am biased since this is what I do.
I’m Dan Johnson, CFP®, founder of Forward Thinking Wealth Management. I run a flat-fee financial planning and investment management firm located in beautiful Akron, OH. Although I am in Akron, OH, I work with clients regardless of location. I cater to owners of equity compensation positions who are looking to organize their financial lives, keep more of what they make, and do the things they want in retirement and even now.