Concentrated Stock Position – Meaning, Risk Factor, Strategy to Diversify & moreLast Updated Date: Aug 30, 2023
Know everything about Concentrated Stock Position & how it can be a risk in trading. Find all details like the strategies used to diversify these stock positions aswell.
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What is Concentrated Stock Position?
Sometimes owing a massive stock position can trigger big challenges for a trader.
For instance, putting the investment portfolio’s large share solely in a single stock perhaps end up deriving unwelcomed risk to your entire wealth.
At that time, most of the traders prefer to choose diversification to get over the situation, e.g., a trader tries to sell purchased stocks of the company.
But traders find it hard to diversify concentrated stock position because here tax crops up as a significant barrier.
Especially, it becomes a problematic situation for those traders who have a large holding in their investment portfolio for a long time.
So what’s the best strategy to employ that can effectively assist the trader in diversifying a concentrated stock position and minimize the tax on capital gains?
Let’s begin the discussion on this most critical topic putting most of the traders into trouble.
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Why is Concentrated Stock Position is a Risk?
Tax isn’t the only tension-deriving factor for traders, but the further risk associated with concentrated stock position also comes in the list.
If a company goes bankrupt over time and its stock’s value also goes to zero, it can trigger a problem for you if you’ve purchased that company’s stock.
Most of you are perhaps well-familiar with these events that usually happen in the trading sector that ends up ruining the financial future for many.
Another common risk associated with concentrated stock is when a company under-performs for a long time.
For instance, the stocks of the company become a liability for the trader, and value-generating asset transforms into a problematic asset.
In most instances, volatility in the market also becomes a risk-driving factor.
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Strategies to Smartly Diversify a Concentrated Stock Position
Here are the various strategies which can reduce the risk & help diversify concentrated stock positions –
Donate Shares to a Trust
One of the simplest yet successful ways to diversify a concentrated stock position is to donate your shares to a trust.
In this way, you’ll be able to mitigate the risk of excessive tax, for instance, since you aren’t giving them money, but donating few portions of your shares, you can receive a tax deduction.
However, gifts to the trust can be viewed as an irrevocable donation.
A charity can later sell these gifts and end up generating income without worrying about tax because the obtained amount is for non-profit purposes.
Gifting Stocks to Family
It’s another one of the popular gifting strategy being widely used among traders. The strategy can work amazingly for you because you simply gift stock to family members or children.
For instance, if your children have recently turned adults, as a stock owner, you can provide them financial help through your stocks.
Such as, you can help children by supporting them with a down payment for their house, car or trip overseas.
Therefore, kids can use the amount obtained from the selling of these stocks and move on.
If your kids are younger adults and free of tax concerns, then this strategy perhaps works best for you.
Structured Stock Selling
You can sell a portion of the stock outright through this strategy. But make sure that the gain obtained from long-term capital can tax-burden on you.
For example- if the investment is held for more than one year or at least one year, it’ll be taxable.
On the other hand, if the investment is held for less than a year and sold only to gain purpose, it’ll be taxed higher than ordinary tax rates.
Therefore, the best way to mitigate these irritating tax bites is to set a schedule and sell stock periodically, such as, you can sell them on a quarterly basis.
However, you can schedule as per your choice, because the main idea behind using this strategy is to reduce position while making significant progression.
Also, by doing this, you sometimes get more fruitful opportunities in future.
If you find someone going through the same situation and want to get over the problems related to concentrated stock, then both of you can consider choosing an exchange fund as the best solution.
The investors create a pool of concentrated stocks together and diversify their position in terms of “funds.” Simultaneously, they minimize their taxes and get rid of risks.
However, it has a little shortcoming because the investor is likely to have no liquidity. Perhaps he pays high fees in most instances.
Possible that the other investor isn’t good in hedging their risks, especially while selling off their stock position.
Rebalance with a Completion Fund
It’s one of the simplest approaches to diversify your concentrated stock position effectively.
Traders can diversify a single position with the completion of the fund, such as by initiating selling of holding in small portions over time and purchasing more diversified portfolio for reinvestment purposes.
As compared to exchange funds method, the investors can get better control over assets through this strategy.
Ultimately, a trader gets the better result for an adequate diversification within a short time.
Stock Protection Plans
Stock Protection Plans (SPPs) is quite a new way to diversify a concentrated stock position without worrying about tax. SPPs work more like insurance, but for diversification, it’s effective.
For instance, under SPP, investors holding diversified pool stocks, in which cash is representing 10% of the stock value against the securities that investor is willing to purchase.
Moreover, in Stock Protection Plans, investors will have to pay 2% annual fee and 2% upfront on a holding of five-years. After these five years, it’s possible that the stock value goes down.
Thus, the fund is likely to compensate to the investors. But during the recession, when the values of stocks start declining significantly, the challenges start emerging.
For instance, funds will fail to compensate everyone; thus, the owner will feel a risky environment around.
It’s one of the strongest approaches related to hedging strategy, and most of you are perhaps familiar with it.
The method involves the purchasing of the put option (long-dated) on the concentrated stock holding, including the sale of the call option (long-dated).
However, owing to the potential gains or losses, a collar must provide enough room, so it doesn’t appear as a constructive sale and avoid making it a subject to tax.
In an equity collar, the owner obtains the right through Put Option to sell their position in future at a given price. Thus, it ends up providing them with downside protection.
On the other hand, the call option generated sales bestows investors with premium income and this income; they are allowed to use as the payment for the purchases (in the put option).
Even though investors want to generate additional income, they can do so by selling a ‘call option’ along with a higher premium. It’ll end up creating net cash inflow deriving profits for the investors.
Conclusion – Concentrated Stock Position
Beyond doubt, the large concentrated stock position can trigger challenges for an investor, especially when they are trying to diversify their position to reduce risks.
Alongside financial harm, the investor can also confront liability issues if the company goes bankrupt over time.
Similarly, if we talk about tax, so the above strategies can assist you a lot. These strategies can lessen the tax burden on you, and you’ll be effectively diversifying your concentrated stock position.
Still, if you encounter any problem, don’t forget to take the advice of an accountant and financial advisor.
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