If you’re familiar with the saying “don’t put all your eggs in one basket”, you probably know that it can refer to a variety of life situations. One of those situations can happen to investors when you own a lot of one particular company–when your “eggs” are shares of stock, and “one basket” is a single company.
We’ve talked a lot about the benefits of a diversified portfolio, but the situation I’ve just described, where much of a portfolio is concentrated in a single company or even a few companies, is the opposite of diversification. I don’t recommend it.
Investors with concentrated stock positions generally take more risk to achieve the same potential return as those who diversify.
There are two common ways that investors end up with concentrated stock positions. The first is when an investor thinks they know more than the markets, so they pick a particular company or sector and invest heavily in it. That can work great, until it doesn’t. The dot-com bust of 1999-2001 is a perfect example, where internet companies saw stock prices go higher and higher before finally crashing. Many companies saw their stock price fall 90% or more.
The second common way people end up in a concentrated position is by working for a very successful company. People working at companies like Apple, Google, Tesla, NVIDIA, Facebook, and Microsoft have seen the value of their company surge over the years. Most of these companies have employee stock programs, where employees get special pricing on a certain amount of company stock each year. Someone who joined Tesla 10 years ago has watched its stock price go up 30-fold, from $15 to around $450. That person is likely a multi-millionaire if they bought company shares each year, and Tesla stock could easily make up 90% or more of their wealth.
Once you find yourself in a concentrated stock position, if you’ve made money on your investment, it can be tricky to get out of it without triggering huge tax consequences! In our example above, a Tesla employee who spent $100k on company stock over the past 10 years would potentially have millions in capital gains to pay taxes on when they sell.
Because these situations are not all that uncommon, the financial industry has worked to find ways to help investors reduce their concentrated positions without taking a big tax hit. Two of these methods are the Exchange Fund and Section 351 Exchange ETF. They work a bit differently, but each can help an investor to diversify an existing position or positions while deferring capital gains taxes.
With an Exchange Fund, let’s say that you have $1 million in Apple stock that you would like to diversify. Meanwhile, imagine 999 other investors like you, each holding a concentrated position in a different company. You move your Apple stock into the Exchange Fund, and in return you get a basket of stock consisting of a little bit of each of the 1,000 company shares
that were put into the exchange. I am greatly simplifying the Exchange Fund in this example, but that’s the basic concept.
Another option is a 351 Exchange ETF, where you could put in your shares of several different concentrated stock positions. Maybe you have a $5 million portfolio (well done!), with $600k of NVIDIA, $400k of Apple, $250k each of Google, Palantir and Tesla. That’s a lot of money invested in only a few companies—not good portfolio diversification. The 351 Exchange ETF allows you to exchange your “unwanted” positions for an ETF without triggering capital gains taxes. Again, this is a dramatic simplification of how the 351 Exchange ETF works, but you get the picture.
Because of specific guidelines and requirements for investing in these special funds, you are typically required to have a certain minimum level of investments and work with a professional advisor. These investments can be a bit complex, and I would never recommend investing in something that you (or your financial professional) don’t understand.
If you are fortunate enough to find yourself in a concentrated stock position with large gains, know that you have options. Many people assume that they either need to sell and take a big tax hit, or hold on to the concentrated position. That isn’t true, and you’ve been introduced to two options here. Diversification isn’t about chasing the biggest winner—it’s about protecting what you’ve built.
How ever you choose to allocate your assets, invest smartly and invest well!
Larry Sidney is a Zephyr Cove-based Investment Advisor Representative. Information is found at https://palisadeinvestments.com/ or by calling 775-299-4600 x702. This is not a solicitation to buy or sell securities. Clients may hold positions mentioned in this article. Past Performance does not guarantee future results. Consult your financial advisor before purchasing any security.
