Many people are familiar with the phrase, “Don’t put all your eggs in one basket.” This phrase originated in the famous novel Don Quixote by Miguel Cervantes in 1605. The term refers to the idea that you should not be overly dependent on any single thing. This idea is synonymous in a portfolio context with the need for proper investment diversification to manage risk.

Concentrated stock risk refers to the inherent danger in holding a substantial portion of your investment portfolio in a single or small number of stocks. When a portfolio has a sizable portion invested in one holding or area of investment, the entire portfolio return is highly dependent on the concentrated holding(s) return.

If the investment performs well, you may earn significant gains. However, this can create substantial losses if the concentrated investment performs poorly. Generally, a single position of 10% of a portfolio can be considered concentrated, while single positions of more than 20% may create significant risk in a portfolio.

There are several key factors to consider when evaluating concentrated stock risk:

  1. Diversification: Famed Economist and Nobel Prize winner Harry Markowitz is credited with saying, “Diversification is the only free lunch in finance.” The key insight provided was that by holding a basket of investments, you mitigate the risk of any single investment or, in financial terms, idiosyncratic risk. The returns and risk of a portfolio that is concentrated in a single stock, sector, or even asset class will be driven by the performance of that concentrated position. This can generate excess returns if the concentrated area performs well but also leave you vulnerable if that specific company or sector underperforms. Investors with a properly diversified portfolio may enjoy positive returns and possibly significantly reduce risk. This is often the longer-term goal when managing a concentrated portfolio.
  2. Volatility: Concentrated portfolios are often subject to greater volatility than diversified portfolios, as movements in the concentrated position can have a larger impact on your overall portfolio value.
  3. Liquidity Risk: Investors may face challenges when attempting to sell a concentrated position if the market is not liquid for that investment. A mismatch between buyers and sellers can create selling pressure, potentially leading to a price decline.
  4. Company-Specific Risk: JP Morgan analyzed a sample of more than 13,000 large, mid, and small companies included in the broad Russell 3000 stock index from 1980 -2014. The study found that approximately 40% of stocks examined “suffered a permanent 70%+ decline from their peak value.” All stocks have unique risks, including operational risk, poor management, financial structure, as well as legal and regulatory risks. These risks can create significant danger when an investor is focused on a single name. [1]
  5. Tax Implications: Positions that are concentrated in one position are often highly appreciated from the purchase value. Any sale of positions that have large embedded gains can result in a sizable tax liability.
  6. Emotional Bias: Investors can develop emotional connections to stocks. The most common result is from an attachment based on prior performance, i.e., “This stock has done well by me, so I will be loyal to the company.” Investors may have a familial connection as well; one common example including, “Dad worked at XYZ for years, and that allowed him to pay for my college.” This emotional bias can cloud judgment and lead to suboptimal investment decisions.

There are several approaches to managing the risks and opportunities of holding a concentrated stock.

Common approaches often fall into two major categories: diversification and implementation of risk management strategies.

Diversification

Diversification is typically the ultimate objective for managing a concentrated position. Investors may choose to gradually sell the position over time, often to spread out the tax implications, and then reinvest the proceeds in a more diversified portfolio.

Exchange Funds may offer an alternative that can provide immediate diversification. Traditional exchange funds do not eliminate the embedded tax liability but will allow investors to mitigate their risk by contributing their position to a diversified stock pool. Investors can achieve similar results by using options to create a “synthetic” exchange fund. Both approaches rely on diversification to reduce single-stock risk.

Risk Management Strategies

Using options to hedge concentrated stock positions is a common strategy many investors employ to protect against downside risk while potentially maintaining exposure to upside gains.

Below are 3 common strategies:

  1. Protective Put: A protective put involves purchasing put options on the concentrated stock position. Put options give the holder the right, but not the obligation, to sell the underlying stock at a predetermined price (the strike price) within a specified period (until expiration). By buying put options, investors can potentially protect their stock holdings from a decline in value. If the stock price falls, the put options will increase in value, generally offsetting some or all of the losses on the stock position.
  2. Collar Strategy: A collar strategy involves simultaneously buying protective puts and selling covered calls against the concentrated stock position. This strategy sets a floor (through the protective puts) and a ceiling (through the covered calls) on the stock’s potential price movements. The investor sacrifices some potential upside gains in exchange for downside protection. The premiums received from selling the covered calls can help offset the cost of purchasing the protective puts.
  3. Costless Collar: A costless collar is a collar strategy that utilizes a protective put and covered call with the premium (income) received from the sale of the call option equal to the cost of the protective put. This creates a floor on the stock price with no cash outlay required for the strategy. It is important to note this is not a risk-free strategy. This strategy provides downside protection at no upfront cost but caps the potential upside gains. Investors may forego significant gains if the underlying stock appreciates. Investors also run the risk of the call being exercised causing the stock sale, which could create a tax liability for an investor with a low-cost basis.

Before implementing any options strategy to hedge a concentrated stock position, investors should carefully consider their risk tolerance, investment objectives, and the specific characteristics of the stock and options involved. Investors should consult with a financial and tax advisor or options specialist to ensure the chosen strategy aligns with their goals and circumstances.

Disclosures

All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with a tax professional before implementing any investment strategy. Investment Advisory Services offered through SAX Wealth Advisors, LLC, an Investment Advisor with the U.S. Securities & Exchange Commission. Registration does not imply a certain level of skill or training.

The information presented in this blog is the opinion of SAX Wealth Advisors, LLC and does not reflect the view of any other person or entity. This is for information purposes and should not be construed as an investment recommendation. Past performance is no guarantee of future performance.

[1] https://privatebank.jpmorgan.com/content/dam/jpm-wm-aem/global/pb/en/insights/eye-on-the-market/eotm-the-agony-and-the-ecstasy.pdf