Reflections

4 Strategies to Help Preserve Gains from Your Company Stock

By Sean Condon, CFP®

What if the source of your wealth creation became the biggest risk to your wealth preservation?  Well, many successful entrepreneurs and executives find themselves in this exact position. If you have built wealth from equity-based compensation, you likely have a large amount of your net worth tied up in low-cost basis stock or company options. You also may have motives – good and bad – why you want to hold on to such a concentrated investment.  Here are some reasons why it makes sense to diversify your portfolio, and common ways to do so strategically.

Single Stock Risk

Individuals typically show extreme loyalty to their company and never want to sell their equity. This makes sense, after all if you are fortunate to be in a position of concentrated wealth in a single stock, it is that investment’s returns that got you here.  But it is dangerous to feel that any one company is bullet proof.

Concentrated stock positions are inherently risky and far more volatile than the market. Without diversification, there is nothing to offset the risk of a bad event happening to a single company, potentially leading to a catastrophic loss of capital and everything you have worked for. Increased volatility and no downside hedge can lead to a disastrous scenario of losing all of your sleep or losing all of your money.

The saying, “without great risk, there is no great reward,” is undoubtedly true.  Equally important is the question “what reward do I need?”  Successful individuals who have already achieved great rewards need to ask themselves this question again.  Of course, another 50x investment would be outstanding.  But what if a portfolio could allow you to retire early, build another company, or live without financial stress.  Any of these goals can be achieved with far more certainty when using a disciplined and diversified investment approach versus a concentrated stock investment.

Diversified Investment Returns

Aside from the risks mentioned, there is evidence to suggest that concentrating your stock in one company results in below-average returns.  The chart below shows the 20-year returns (ex-dividends) for Fortune’s “Most Admired” companies of 1999, both their absolute return and relative return as compared to the S&P 500 Index. On average, the stock returns of the “Most Admired” individual companies underperformed the Index by 80.5%.

The investment darlings of today are not guaranteed to be the companies that lead the way tomorrow.  Even if your company’s performance helped you create wealth for yourself, there is no promise that this winning streak will continue.  Diversification not only can mitigate risk, but it can help your long-term returns.

So, how can you diversify your concentrated position?

1.   Strategic Tax Planning

Even individuals who are convinced they need to reduce a concentrated stock position will have a challenging time doing it.  Capital gains taxes on appreciated stock can be as high as 23.9% depending on your income.  To sell an entire position at one time will result in an unwanted tax bill that is better to be avoided if possible.

Implementing a strategic tax plan to reduce a concentrated stock plan can save you on taxes.  For example, a set schedule to sell a certain amount of stock every year can defer taxes and spread the bill over time.  Limiting how much capital gains income you realize every year may also help manage your tax bracket, potentially lowering the tax rate you pay on the sale.

Tax-loss harvesting is another strategy to help manage around concentrated stocks.  In the event you have other portfolio losses, selling those investments and realizing losses will offset any gains you take on your company stock.  You can re-purchase investments sold after 30 days, ensuring your investment positioning in the diversified portfolio is relatively unchanged, but the tax savings is recorded.

2.   Use Options to Hedge Your Position

Another way to control downside risk in a concentrated position is to utilize options. There are several types of options, and combinations of options, that can be used, including:

  • Covered Call: Individuals who own a stock can sell call options on the underlying security. The sale of these options creates an income stream, which can be used to offset any stock decline or pay taxes on planned sales of the underlying security. The tradeoff for selling calls is it creates a ceiling on possible return; if the underlying stock appreciates you do not earn the entire upside.
  • Equity Collars: An equity collar is a covered call strategy where the income from selling the call options is used to buy put options. The put option acts as a hedge against downside risk, so creates a floor and ceiling “collar” around your potential return.  You are guaranteed to be able to sell your shares at the option price even if the market price of the stock drops to zero.

3.   Gift Stock to a Charitable Trust

Concentrated positions can also be diversified by gifting shares of stock to a charitable trust. Individuals do not have to pay any taxes on gains for shares gifted to a charitable trust fund.  In addition to diversification, this strategy provides tax benefits and allows you to donate to a cause you care about.

Gifting stock to a charitable trust can also provide an income stream during your retirement. For instance, a charitable remainder trust (CRT) provides a current income stream to the donor and their beneficiaries for a specified period, and the remaining amount is then passed to the charity of the donor’s choosing. A charitable lead trust (CLT), on the other hand, distributes the current income stream to the charity and the remaining amount is left to the trust, or the donor’s heirs.

Both trust options can be used to diversify your position and hedge against downside risk.

4.   Exchange Funds

An exchange fund (not to be confused with an exchange-traded fund) can be used to mitigate risk by allowing you to trade some of your concentrated position for shares in a diversified fund. It is a pool of stock shares from different companies, created by an agreement among a group of investors whereby each investor contributes shares of a single company’s stock in exchange for shares of the diversified pool.

The exchange is not considered a sale until the investor cashes out their shares of the fund. This means that you can defer capital gains tax while also increasing your overall level of diversification. This option may also work well for restricted stock holdings in situations where an outright sale is prohibited.[1]

Find Out More

If you’re invested in a highly concentrated stock position and want to learn more about our strategies for entrepreneurs, download our eBook An Entrepreneurs Guide to Personal Finance.

At Windgate Wealth Management, we can help uncover your financial blind spots and navigate the inherent risks that come from concentrated positions. Reach out to us by calling (844) 377-4963, emailing windgate@windgatewealth.com, or booking an online appointment here.

[1] https://www.investopedia.com/terms/e/exchange-fund.asp

Perritt Capital Management, Inc. is the Registered Investment Advisor for Windgate Wealth Management accounts and does not provide tax advice. Consult your professional tax advisor for questions concerning your personal tax or financial situation and your insurance agent for insurance advice.

Data here is obtained from what are considered reliable sources; however, its accuracy, completeness, or reliability cannot be guaranteed.

First published March 2022.

Past Performance does not guarantee future results.

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