by Chris Bixby, CFP®, EA
Senior Vice President
Portfolio and Wealth Management
In the 1950’s Harry Markowitz published his article “Portfolio Selection” which set the framework for what he dubbed Modern Portfolio Theory (MPT). This theory became so widely adopted that Markowitz was awarded the Nobel Prize in Economics in 1989. A basic tenant of the investment philosophy outlined by MPT says that diversification of portfolios reduces the volatility of the portfolio, which in turn can improve investment performance over multiple market cycles.
This concept may be best demonstrated by considering the following example: if a portfolio loses 10% of its value, it needs to earn 12% to return to its original value. However, if the portfolio loses 50% it will require a subsequent 100% return to get back to even. In other words, the higher the volatility of a portfolio, the harder it is to recover from large declines.
While wealth has historically been created through concentration of wealth in a business, real estate, or an individual company stock, diversification is often credited with helping to retain that wealth, even after portfolio distributions begin. Where MPT shines is when you need to begin distributions and consider the protection of your wealth. At that point, concentration exposes you to excess risk and diversification becomes critical.
Tax Consideration of Concentrated Positions
One of the biggest obstacles to diversification is taxes. In many cases, the concentrated position that has appreciated over time has a low-cost basis. If the investment isn’t in a retirement or other tax deferred account, the taxable gain that is realized when that investment is sold can be significant and thus a deterrent to investors who want or need to diversify.
Thankfully, there are several strategies available to mitigate both the concentration risk and the tax impact. The right strategy, or strategies, for doing so will ultimately depend on several factors but a good starting place is to consider a few questions:
How much income do you need from your investments and what is the timeline for needing liquidity?
How much volatility are you able to tolerate during the distribution phase of life?
What is the expected trajectory of this investment?
Efficiency of Distribution
Efficiently distributing and reinvesting your concentrated investment requires thoughtful management and typically is implemented over several years. One of the top considerations, if the strategy involves selling the position, is to work closely with your professional partners to maximize the after-tax value of the asset. This might include establishing an annual tax budget that allows for management of income to remain within targeted tax brackets from year to year. Effective implementation of tax bracket management might also include tax loss harvesting strategies to offset realized gains, deferring other income by maximizing pre-tax retirement contributions, or incorporating strategic charitable giving.
If charitable giving is an important part of your annual planning, concentrated positions can be reduced by donating highly appreciated investments to your preferred charity. Whether to a charity directly, or to a Donor Advised Fund, the unrealized capital gains can be avoided, while also potentially creating a tax deduction that can be used to offset other gains generated by selling more of the concentrated position. These can then be used to reinvest in a diversified portfolio. This strategy can further your charitable goals while speeding up diversification efforts.
Using tax advantaged diversification investments, such as Opportunity Zones, Delaware Statutory Trusts, and Exchange Funds, can also help to speed up the diversification process. Note that these investments are very specific to each individual and carry their own unique risks, which should be properly understood before investing. Each should be considered with careful thought, caution and the help of your entire advisory team.
Another strategy for those with a large concentration in a publicly traded stock is using options. There are a few options strategies that may be considered:
Buying protective “puts” which give you the right to sell your shares at a predetermined price if the stock price drops, effectively putting a floor under the position and mitigating downside risk.
Selling “calls” where you agree to sell some of your shares at a higher predetermined price at a set time in the future.
These strategies are complex and require thoughtful consideration of the potential future outcomes, but in the right situation can help reduce downside risk, may create additional income and could capture a future “pop” in the stock price sufficient to pay the tax on the gain triggered by the sale.
Establishing Your Diversification Plan
This serves as an overview of the potential strategies that you might consider if you find yourself with concentrated investment in need of diversification. The investment and wealth management professionals at Ferguson Wellman and West Bearing can work alongside your tax advisor to evaluate your concentrated position(s) and help you outline the optimal approach in light of your unique needs, goals and tax circumstances.
If you need assistance in planning for a concentrated position, please contact your portfolio manager to begin the conversation.
Ferguson Wellman, Octavia Group and West Bearing do not provide tax, legal, insurance or medical advice. This material has been prepared for general educational and informational purposes only and not as a substitute for qualified counsel. We believe the information provided is from reliable sources but should not be assumed accurate or complete. You should consult qualified professionals to understand how this information may, or may not, apply specifically to you.