The Hidden Cost of Holding a Concentrated Position Why Diversification Can Help to Protect Wealth by Baird’S Private Wealth Management Research

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The Hidden Cost of Holding a Concentrated Position Why diversification can help to protect wealth By Baird’s Private Wealth Management Research

Executive Summary Family wealth created by holding a single stock that appreciates substantially in value over time is fairly common. For example, senior company executives receive stock or stock options as part of their compensation, investors benefit from superior appreciation of one stock relative to the rest of their portfolio or family members inherit a large position in a single stock. Regardless of how the concentrated position is acquired, it results in a disproportionate allocation of wealth, which exposes the family to undue risk that should be understood and managed. Whether investors understand the risks of holding a concentrated position or not, there is a tendency to hold onto these positions. Corporate executives may face insider selling constraints or concerns about how a sale would affect the market price of their company’s stock. Other investors simply have an emotional attachment to the stock. Many investors are concerned about the tax implications of selling. Despite these seemingly valid reasons, there is a critical point for most investors and families where the desire for wealth, income and lifestyle preservation outweighs the need for further wealth creation. This is especially true when investors approach retirement or life events during which they will more heavily rely on their accumulated wealth. The goals of this paper are to educate investors about the hidden risks associated with holding significant wealth in concentrated positions and to suggest strategies to help mitigate and manage those risks. The Risk/Reward Implications of The results of this study showed Defining a Concentrated a Concentrated Position that over one-third of the individual Position Investors who have benefited from stocks underperformed our 60/40 A concentrated position occurs holding a concentrated position often diversified portfolio, and that all of when an investor owns shares believe that past performance will the individual stocks showed much of a stock (or other security continue indefinitely, and may find higher volatility. The average stock’s type) that represent a large it difficult to imagine a downside. volatility was more than three times percentage of his or her overall While it’s tempting to believe a that of the diversified portfolio. There portfolio. The investor’s wealth stock’s market outperformance is no perfect way to know which becomes concentrated in the will continue, studies show that stocks will be the winners over the single position. Depending on investments in a diversified portfolio long term, and the cost for being the volatility of the stock and can produce greater long-term wealth wrong can be high. For example, the the size of the client’s portfolio, a than investments in a concentrated return of 55 stocks failed to keep pace position is often considered to be position, with significantly less risk. with inflation over the period, and concentrated when it represents 37 of the 309 stocks had a negative 10% or more of one’s portfolio. In order to better understand the return for the decade. risk/reward trade-off of holding a concentrated stock position, Baird A good example is General Electric. constructed a hypothetical diversified The chart below compares the portfolio consisting of 60% equities performance of General Electric’s and 40% fixed income and compared stock to the diversified portfolio over it with the 309 individual stocks that this 10-year period. GE experienced remained consistently in the S&P a 1.9% annual rate with 28.9% 500 Index for the 10-year period of volatility, while the diversified September 30, 2006, to September portfolio generated a positive annual Concentrated Equity Position: 30, 2016. return of 5.8% with much less “What If” Analysis

Single Stock Position vs Diversified Portfolio $200,000 Growth of $100,000 Investment, Past Ten Years GE $180,000 $175,467 Diversiﬁed Portfolio $160,000 Diversiﬁed Portfolio $140,000 GE Diversified Portfolio $120,000 $120,154 10-Year Higher $100,000 1.9% 5.8% Annualized Return Return $80,000 10-Year Less 28.9% 9.2% $60,000 Annual Volatility Volatility

$40,000 GE Diversified Portfolio (total=100%) $20,000 Equity 0 Large-Cap Value 14.0% Large-Cap Growth 12.0% Sep-06 Jul-07 May-08 Mar-09 Jan-10 Nov-10 Sep-11 Jul-12 May-13 Mar-14 Jan-15 Nov-15 Sep-16 Mid-Cap 8.0% Source: FactSet Research Systems; Baird analysis. Small-Cap 4.0% The following indices are used to represent the diversified portfolio: Large-Cap Growth: Russell 1000® Growth International 14.0% Index; Large-Cap Value: Russell 1000® Value Index; Mid-Cap: Russell Midcap® Index; Small-Cap: Russell 2000® Index; International: MSCI EAFE; Taxable Fixed Income: Barclays Capital Intermediate US Govt/Credit Taxable Fixed Income 40.0% Index; Satellite: MSCI Emerging Markets Index, Barclays Capital US Corporate High Yield Bond Index, Satellite 8.0% DJ UBS Commodity Index, DJ US Select REIT Index. Russell® is a trademark of the Frank Russell Company. Indices are unmanaged and a direct investment can not be made into an index. The analysis was performed by Baird’s Private Wealth Management Research department. - 2 - volatility (9.2%). Importantly, this is As Table B shows, Investment II, the less not an isolated case. Baird has calculated volatile of the investments, generates similar results for dozens of companies, a much higher compounded growth including US Bank, Cisco Systems, rate of 9.9%, compared with 2.5% for Exxon Mobil and FedEx. In many of the Investment I. As a result, a $1,000,000 “what-if ” analyses we conducted, the investment in Investment II grows to diversified portfolio outperformed the $1,207,500 in two years. That’s over single stock position, and in all $150,000 more than Investment I cases the diversified portfolio had simply because of the investment’s lower lower volatility. volatility. In summary, the more an investment’s return fluctuates year by So why does a diversified portfolio often year (i.e., the higher the volatility), the outperform a single stock position? greater the drag on the compounded The answer lies in the lower volatility. growth rate and the lower the future As our study and others like it have wealth. Thus, controlling volatility and indicated, greater volatility in a portfolio risk through proper diversification does reduces compounded growth rates and matter in portfolio management. future wealth. The example in the tables below illustrates this point through two While investors may be tempted to hypothetical investments that generate hold a concentrated stock position in the same average annual return of 10%, the hope of greater profit, they may fail but with varying levels of volatility. to understand that they are not being In Table A, Investment I averages a compensated for taking this risk. In 10% return but is the more volatile theory, stocks are riskier investments that investment, increasing 50% one year and should provide higher returns than less decreasing 30% the next. Investment II risky investments like Treasury securities. also averages a 10% return; however, it is However, the risk/reward premium less volatile, up 15% and 5% in the two turns against the investor when too few years, respectively. stocks are owned, and especially when the investor holds a single or large, TABLE A: dominant position. Returns become too Averages Can Be Misleading reliant on the fortunes of one company Investment Year 1 Year 2 Average Volatility (exposing the investor to significant company-specific fundamental risks) I 50% -30% 10% 40% and to a single industry (exposing the investor to sector-specific risks). As a 15% 5% 10% 5% II result, it is clear that investors should choose to diversify a concentrated stock TABLE B: position whenever possible. Why Volatility Matters

Investment Original Investment Year 1 Year 2 Compounded Growth Rate

I $1,000,000 $1,500,000 $1,050,000 2.50%

II $1,000,000 $1,150,000 $1,207,500 9.90%

- 3 - Why Are Some Investors The True Tax Consequences Today’s Capital Gains Reluctant to Sell? of Selling Rate Environment Despite this compelling argument, One of the biggest objections to It’s widely agreed that tax we have found many investors selling a large appreciated stock considerations, while important, are reluctant to sell concentrated position is the need to pay income tax should not be the only reason for positions. A few of the most on the gain. With a cost basis that can making an investment decision. common reasons investors don’t sell be as low as zero, the tax implications The investment merits of owning are summarized in Table C below. in dollar terms of a sale can seem the stock should supersede the Although many of these reasons are significant. However, we have already tax considerations of selling. valid in the eyes of the investor, the shown how a diversified portfolio can Nevertheless, investors who logic supporting diversification is build greater wealth with less risk than currently own a large stock compelling. We will now turn to a single-stock position. In the study position should consider the some ways an investor can successfully referenced, even in a decade when the impact of capital gains tax rates diversify and minimize the risk of a S&P 500 was up 5.3%, 25 stocks when contemplating a sale. concentrated position. were down 20% or more in value at While higher than they were in the end of 10 years – roughly the early 2000s, long-term capital equivalent to a payment of 15% gains rates are still at or near historical lows for most taxpayers. TABLE C: Those paying the top federal (and Why Investors Don’t Sell possibly state) capital gains rates The Rationale for Holding The Logic of Diversifying may want to be more diligent in managing their tax liability. A They want to avoid a “certain loss” due to the tax This is perhaps the most prevalent of all reasons consequences of selling. to hold, yet often, over longer time horizons, an qualified tax advisor may be able investor can recoup the tax cost and continue to to offer strategies that reduce, or build wealth with a lower risk portfolio. in some cases eliminate, the tax They assume the future will be like the past. Even if the stock has been successful in the past, impact of the sale with certain no one can predict the future. tax-planning techniques. They are overconfident in the stock’s prospects There is a misperception that can occur when an If a taxpayer’s capital gains rate is (especially if it is their employer). investor works for a company and has been very expected to rise in the future, successful there. Again, no one can predict the future. either due to higher income or They are lured by the possibility of a big win and feel While one may view situations like Enron and anticipated tax law changes, a their stock is immune from a significant downfall. WorldCom–where stocks totally collapsed–as greater tax burden could exist for isolated events, owners of these equities never anticipated what happened to them. those who sell large concentrated positions. Under this scenario, They fear they will regret selling the stock if the price By focusing on the long-term potential and lower continues to rise. risk of the new, diversified portfolio, an investor can investors should be aware that overcome these regrets. they will likely need more time They cannot bring themselves to sell the stock at a The stock may never reach those levels again; it’s in the future to recoup the tax price below its former high. They are waiting for the better to put the money to work in a more prudent, expense of the sale – all else being stock to “come back.” diversified strategy. equal, suggesting a sale sooner They feel loyal to a stock they inherited from a In fact, diversifying that position may be a wiser way rather than later. trusted family member. to maintain that legacy. They are legally restricted from selling. Even when selling the stock outright is not an option, there can be other alternatives. For more information see sidebar, “Solutions for Restricted Stock Holders.”

- 4 - federal and 5% state long-term capital portion (i.e., partial sale) of a Solutions for Restricted gains. Hypothetically, had an investor concentrated position is better than Stock Holders sold a position in one of those names doing nothing. However, investors In some cases, corporate insiders at the beginning of the decade and lost must remember the end goal of may be prevented from selling 20% to long-term capital gains taxes, reducing volatility and risk to their due to regulatory constraints, they would have been no worse off wealth, which will often require a such as prohibition from selling had they placed the proceeds under a significant, if not total, reduction of during blackout periods or when mattress for the 10 years, and would the concentrated position. in possession of material have been considerably better off had nonpublic information. The Determining how much, if any, to they invested the proceeds in a Securities and Exchange continue holding requires a diversified portfolio despite the Commission (SEC), recognizing thoughtful, unbiased review of the significant up-front tax bill. that corporate insiders were investment prospects for the stock. It greatly restricted by these rules, The longer an investor’s time horizon, may be that the best approach for a created a preplanned sell program under Rule 10b5-1. By adhering the more likely he or she will be able portfolio is a complete liquidation – to strict SEC guidelines, insiders to recoup the entire tax cost. Much and given the potential influence of entering into 10b5-1 programs depends on the size of the tax bill, emotion, a trusted outside advisor may are allowed to execute pre- which in turn is a function of capital need to assist an investor in making programmed sales when they gains tax rates. Investors should keep this decision. would not otherwise be allowed in mind that current long-term capital to do so. In all cases, owners of If the investor is not restricted from gains tax rates are still at or near their stock they cannot readily sell selling, the fastest way to reduce the historical lows for most taxpayers. (See should take a careful look at how volatility and risk in the portfolio is to sidebar, “Today’s Capital Gains Rate the stock position fits into their execute the sale in one transaction and overall portfolio strategy, and Environment” on page 4.) reinvest the proceeds to create a make sure they diversify around the position. For example, if an Some of the factors to consider when balanced portfolio. This is a good way executive has 10% of his portfolio deciding whether to sell include age to bring the risk level of the portfolio in company stock, the remaining and health, current portfolio assets down quickly and efficiently. However, 90% can be invested in a way and how well these assets are for a variety of reasons, this isn’t always that helps counterbalance the diversified, cash flow requirements, feasible, so a staged sale may need to additional risk of that position and expected portfolio contributions be considered. – perhaps with more low-risk securities like Treasury bills. The and withdrawals. The optimal sale Staged Sales goal is to minimize the portfolio’s amount increases with longer time overall volatility level in order horizons, lower risk tolerances, greater Selling a large position at one time can to preserve as much wealth as volatility in that single stock, lower tax sometimes lead to downward pressure possible. In these cases, a personal costs and higher lifestyle spending on the stock price, further reducing Investment Policy Statement can needs. also be a valuable tool in defining the portfolio’s value. At other times, it may be too difficult emotionally for risk parameters and establishing Selling and Diversifying investment guidelines. the investor to sell in one large Diversifying a concentrated position transaction. In these cases, a staged doesn’t mean making a minor sale may be most appropriate. In a adjustment to the portfolio. After all, staged sale, the investor sets a goal of the goal is to significantly reduce the selling a certain number of shares of volatility caused by a concentrated the stock by a certain date. For position, so the diversification will example, the investor wishes to sell need to be meaningful. Selling a 12,000 shares of the stock over the

- 5 - next 18 months. The investor is • Exchange funds allow qualified Special Considerations for willing to sell shares every quarter, investors to exchange a concentrated Stock Options meaning there will be six sales during position for a more broadly Quite often, investors mentally this period. At the end of each quarter, diversified portfolio of stocks account for stock options the investor then would commit to without incurring an immediate tax differently than stocks. In reality, selling 2,000 shares. By making this liability. Essentially, investors stock options are equity holdings commitment, the investor has set the contribute their appreciated stock to and can constitute a concentrated schedule and won’t be swayed by a limited partnership in exchange for position. However, they present emotion, market fluctuations or other an interest in a diversified portfolio. special considerations that require additional planning. events that otherwise might keep him After a period of time, generally or her from selling. The emotion has seven years, the investor can There are unique tax consequences to exercising both been removed from the transactions withdraw a pro rata share of the incentive stock options (ISOs) with a set plan, agreed to by all portfolio. Exchange funds may have and non-qualified stock options involved, that every three months limited liquidity, defer rather than (NQSOs). One of the greatest is a 2,000 shares will be liquidated. eliminate capital gains and be costly, tax trap that can occur when ISOs but they can help work toward a In some cases, executives may be are exercised. When the stock is more diversified portfolio. exercised, no regular tax is due, prevented from selling at certain times but the taxpayer may have to pay because they possess insider • Charitable Remainder Trusts AMT. However, the stock cannot information such as knowledge of (CRTs) help further an investor’s be sold for at least one year to corporate strategy, earnings reports or philanthropic goals while providing achieve this usually favorable tax other non-public information. Timing an immediate tax deduction. The treatment. Later, if the stock is sales between these events (known as sold for a gain, things are good. investor transfers the appreciated However, if the stock suffers a “open window” periods) can be stock to the trust, and in return large decline in value before it is difficult and leaves insiders open to receives an annual income stream sold, the previously determined regulatory scrutiny. In this from the trust. The trust can AMT liability is still due even circumstance, staged selling through a diversify the portfolio, but any taxes though the stock is worth much 10b5-1 plan is one solution. These on the gain are deferred until the less then it was when the ISO was plans specify how much and when a income stream is passed to the exercised. The taxpayer ends up paying tax on the previously much stock will be sold. The sales are donor. At the trust’s termination, the higher value, even though the executed automatically, with no remaining assets pass to a charity the stock is not worth that amount further investor involvement. investor chooses. The investor today. Sometimes, this is referred cannot reverse the transfer once it’s As a result, open window periods are to as paying tax on “phantom done. And, the income stream will income.” The more volatile the not an issue and regulatory oversight not generate as much wealth as stock price, the greater the is greatly reduced. These arrangements selling the stock and keeping the possibility an investor might get are binding and will often require the proceeds. Therefore, the CRT may caught in this trap. approval of the company, so they’re be most appropriate for an investor As a result, advance planning is not for everyone, but they can be a with charitable intentions. crucial. Investors should consult valuable strategy. (See “Solutions for their investment and tax advisors Restricted Stock Holders” on page 5.) • Hedging alternatives are most often before taking action to diversify used by individuals who are a concentrated stock option Other Ways to Diversify position. restricted from selling their shares, or For stock owners unable to divest, whose short time horizon makes there are several alternatives that may selling an unattractive option. A be appropriate: common hedging technique involves the use of “collars” or collar-like

- 6 - strategies. Hedging strategies are It’s All About Protecting complex and can have tax the Wealth implications for the investor. A large stock position acquired Therefore, we encourage clients to through years of executive work carefully with their investment compensation, superior price and tax advisors to evaluate how appreciation or an inheritance can these strategies fit in the context of produce significant family wealth. At their overall wealth management the same time, that wealth may plans. become dangerously concentrated, presenting considerable risks. When Not to Sell As we have discussed throughout this Selling usually doesn’t make sense for paper, there are several thoughtful those investors who expect to approaches investors can consider to bequeath their assets in the near term. reduce their concentrated position and Upon an investor’s death, the heirs diversify their portfolio. We encourage (including the spouse, children and any client who holds concentrated others) may be entitled to step-up the positions to speak with an advisor cost basis of the stock, meaning they about the available options. Families could sell and owe little or no capital with concentrated positions should set gains taxes. In this case, hedging the and execute a professionally prepared position may be a better alternative. plan to help retain and protect their (See “Other Ways to Diversify” on family’s future wealth. page 6.)

Diversification does not assure a profit or protect against loss.