How to guide clients out of big stock concentrations

Concentrated stock holdings carry higher risks of volatility and — once sold in order to diversify investment portfolios — steep tax hits for clients. 

Behavioral biases often linked to one stock due to a client's long-term association with a company through their employment, early investment or another factor are common, according to experts. They represent "a tricky conversation for advisors, but probably one they're pretty commonly having," said Jeremy Milleson, a director of investment strategy with Morgan Stanley- and Eaton Vance-owned asset manager Parametric Portfolio Associates. 

The discussion can begin with an acknowledgement that the large holding is "a good problem to have," and also begs the question of "how do we more tax-efficiently potentially reduce that concentration" without receiving the influx of taxable capital gains, Milleson said in an interview.

"For some clients, maybe the majority of their wealth might be in an individual stock," he said. "For a lot of clients, there is that emotional tie."

READ MORE: Excluding capital gains of $10M — or more — from taxes with QSBS

They probably aren't holding onto notorious examples of companies that experienced steep declines in value such as Enron, Bear Stearns or Sears, but any stock will sustain some losses over time. In five-year rolling periods spanning from 2000 to 2021, the value of every single stock in the S&P 500 dropped by at least 20%; and 63% of them tumbled by 40% or more, according to a blog post by Milleson last month. 

Over a longer period between 1987 and 2023, tracking a wider swath of stocks as a benchmark for the market in the Russell 3000, just 34% of the individual companies outperformed the index, 27% underperformed but still reaped positive returns and 39% lost value, data from BlackRock showed.

"While investors may be tempted to hold a concentrated stock position in the hope of greater profit, they may fail to understand that they are not being compensated for taking this risk," according to a study by the research arm of Baird Private Wealth Management. "In theory, stocks are riskier investments that should provide higher returns than less risky investments like Treasury securities. However, the risk/reward premium turns against the investor when too few stocks are owned, and especially when the investor holds a single or large, dominant position. Returns become too reliant on the fortunes of one company (exposing the investor to significant company-specific fundamental risks) and to a single industry (exposing the investor to sector-specific risks). As a result, it is clear that investors should choose to diversify a concentrated stock position whenever possible."

Clients' refusal to do so may stem from more than a half dozen forms of behavioral biases, according to an analysis earlier this year in Financial Advisor magazine by Larry Swedroe, the head of financial and economic research for St. Louis-based registered investment advisory firm Buckingham Wealth Partners. For example, heavy concentrations in one stock can trigger commitment and confirmation bias, in which investors believe they would be disloyal to sell and tune out evidence that holding on to the same position isn't their best course, he noted. Taxes can play into their reasons for staying the course as well.

"A major issue that often leads investors to fail to diversify their concentrated position is the desire to avoid paying large capital gains taxes," Swedroe wrote. "Before addressing strategies to avoid or at least minimize that problem, I remind investors that there is only one thing worse than having to pay taxes — not having to pay taxes (as happened to those with concentrated positions in Enron, among many others)."

READ MORE: Convincing clients to let go of huge holdings

As an antidote for the possible tax hit, Swedroe mentioned an alternative investment in the form of a leveraged strategy known as variable prepaid forwards, as well as charitable donations or moving the shares into a diversified basket of securities called an exchange fund. However, the latter choice defers the tax hit rather than eliminating it outright, Milleson noted in the blog post. A custom diversification strategy over time through direct indexing could produce losses for offsetting capital gains as well, he wrote.

"Building a customized, staged diversification plan can help spread the cost of diversification over a number of years or make sure the cost stays within a certain gain budget — allowing for greater control of the tax bill and the degree of diversification," Milleson wrote. "This plan can be modified at any time depending on changes in the market or client needs. Using leverage can help increase the losses generated in a direct indexing account and accelerate the diversification."

If the client must hold onto the shares for any reason, an options-based covered call strategy could cut down on their concentration and boost their earnings over time, he added.

With "a lot of different solutions" for concentrated stock holdings and the accompanying tax questions, advisors should take an educational approach in guiding clients through the process, Milleson said. They don't need to wind down all of their holdings in the stock at once, either. 

As advisors inform the customers of the risks of not diversifying, they can "highlight that while being sensitive to the client who probably takes great pride in having built their wealth from this position," he said. "It's worth having those conversations, understanding that maybe it's one of those solutions or a combination of those solutions that's the best fit for the client."