Okay, you’ve come into a situation where one of your positions way outweighs the others. Maybe it did spectacularly well the last couple of years. Maybe your employer compensated you in company stock. Maybe you inherited it. Whatever the case, now you have one position that takes up 30%, 50%, even 100% of your total investment portfolio.
Time to trim it down a bit.
The science and statistics behind asset allocation, modern portfolio theory, and diversification are a topic for another article (or a book). The end result is: diversifying your portfolio preserves your gains in the long run and reduces risk immensely.
That may seem like blunt advice on the face of it, “if your portfolio is too concentrated, diversify it,” but that conceals the considerations you need to make. Most investors with a concentrated position have low cost bases, or lock-up periods, or have some insight into the company they own that brings its own value. Those are the topics we’ll be addressing here.
How large a position has to be before it’s considered ‘concentrated’ is up for some debate, but general wisdom says a position that takes up over 10% of your portfolio is a concentrated position. There are obvious exceptions: ETFs that mimic an index or mutual funds that hold dozens of underlying positions themselves bring some diversity to the portfolio on their own. Your portfolio might consist of only five or six positions, provided that they’re all suitably diverse.
Getting to that state – a diversified portfolio that’s aligned with your risk tolerance and is responsive to the market – is the hard part. This is especially true for investors with extremely low cost bases in their concentrated position. If you earned, bought, or inherited a huge chunk of, say, AAPL, MSFT, TSLA, or NFLX a decade ago you might have a cost basis of 5% of the current value. Almost all of your portfolio is going to be subject to capital gains taxes when it comes time to liquidate it. This, of course, isn’t a concern if your assets are in a retirement account (like a 401(k), an IRA, or a Roth IRA), but in a taxable account like your normal brokerage account, it can be murder.
In a situation like this you have to find a balance between minimizing the tax hit and staying in a risky position. Maybe you commit to eliminating a certain percent or dollar figure of your overweighted position each year; maybe you seek tax mitigation strategies that allow you to move out of that position faster; or maybe you bite the bullet and pay the taxes up-front, knowing that the diversity will make up for it. There are even some useful tools to introduce diversity to a portfolio while minimizing capital gains (like exchange funds or opportunity zone investments) that are available to individuals with very large highly concentrated portfolios.
Our recommendation? Talk to your advisor. Nobody is going to be able to give you a one-size-fits-all path to diversifying your concentrated portfolio. Work with someone that understands your situation to create a path from where you are to your ideal portfolio.
But maybe you have other concerns! What if you have a lock-up period during which you can’t sell those positions? Not to fear. There are ways to minimize the volatility of that portfolio as well, using derivatives or securities that act in a way opposite to your primary holding(s). What if you have some specific insight into that company or sector that makes you feel more comfortable with it? Use that knowledge! Take advantage of your insights and awareness of that security, but don’t discard the years of experience your advisor brings to the table or the hundreds of studies supporting portfolio diversity. Work with your advisor to create a resilient portfolio that leaves room for your expertise. Again, no one size will fit every investor – work with someone you trust and take the time to get it right.
Position concentration is becoming a more and more common concern for our clients. Between Jan 1 2009 and Dec 31 2020 the S&P 500 returned about 12.63% annually. The NASDAQ gained 19.17% per year in the same period. If you were one of the early investors in, say, NFLX you’d have returned 49.68% or about $1.2 million on a $10,000 investment in that time. The task of reducing that position in a way that a) allows for continued growth, b) reduces your risk, and c) doesn’t leave you with a $200,000 tax bill is a difficult one – don’t let it prevent you from making smart choices.