Concentrated Stock: When Does Avoiding Taxes Cost More Than Paying Them?

Key Takeaways:

We often speak with prospective clients who hold concentrated stock positions, driven by tax concerns, limited bandwidth, or high conviction in their company.  Typically, this stock is concentrated in a single company or sector, like tech, and can make an executive’s portfolio highly dependent on the future performance of that business or industry. While the tech industry in particular has been a historical market driver, we’ve also witnessed overnight crashes that have devastated investors' portfolios.

It may feel counterintuitive to sell a stock that has historically worked — and who wants to voluntarily trigger a massive tax bill? But past performance and high valuations do not make a company immune to future losses. On this episode of “On the Minds of Our Clients,” Chief Strategy Officer, John Eing, sits down with Quantum's CFO Dave DeWolf to discuss the risks of holding highly concentrated stock and how diversification can help balance investor expectations for long-term growth. You can watch the full conversation in the video below, or read the summary to learn more.

A few years ago, a prospective client approached Dave after inheriting a $2 million portfolio concentrated in the stock of a single company. The stock they received was not eligible for a step-up in basis and thus had a very low cost basis, which meant the client was facing a roughly $700,000 tax bill if they decided to liquidate the stock. A tax bill of this magnitude is hard to ignore, but it raises an important and frequently asked question: Should you protect yourself from a big tax bill or protect your long-term wealth against concentration risk? Our recommendation was to diversify, following long-established and research-backed investment fundamentals to provide:

While speaking with Dave, our prospect was also floating strategies with a big-city money manager who focused on picking stocks, watching tickers daily, and “beating the market.” The manager assured the prospect that selling would be a mistake, as this company, one in which all their clients were invested, was strong, giving them confidence about the future. As a result, the prospect decided to hold onto the stock.

Three months later, the prospect reached out saying the company’s stock had dropped nearly 20%. While the decline was substantial relative to his net worth, our guidance remained the same: sell and diversify. The silver lining of the decline was that this meant paying less in capital gains taxes. The lower valuation of the broader market at this time also presented a buying opportunity where he could redeploy the capital at a discount. Once again, however, the money manager convinced the prospect to stay put.

Just three months later, the value of the company declined even further, leaving the inherited stock valued at $50,000. At that point, the vast majority of his net worth had evaporated, and whether he held or sold, this loss significantly reduced his flexibility and future security. In this case, prioritizing tax avoidance over prudent risk management led to a far greater loss than the original tax.

While taxes are an important consideration, they should not dictate your investment strategy. One of our investment principles is that "markets are too efficient to try to beat". We recognize that current stock prices continuously reflect the collective information available in the marketplace. In our experience, a major red flag is when an advisor suggests a stock is a “sure thing” based on strong past performance, media hype, or intuition. We don't believe that any investor or manager can consistently out-predict market movements in the long run. Instead, we advocate for evidence-based investment principles, and focus on factors within our control, such as financial planning, tax efficiency, and risk tolerance.

Managing a concentrated position does not require an all-or-nothing approach. The optimal strategy takes a comprehensive approach balancing your tax situation, level of risk tolerance, and most importantly, your goals. We often collaborate with clients to implement methods that support tax efficiency while addressing real-world factors, such as emotional attachments, behavioral biases, lock-up periods, and company loyalty. Here are some deconcentration strategies you may consider:

There are many additional options and solutions, which we can’t cover in a single blog post. However, when facing a concentrated stock position, your strategy should ultimately address what you want that wealth to do for you. Whether your goal is maintaining your lifestyle, securing critical obligations, supporting family and philanthropic causes, your portfolio should empower your life, not dictate it.

Predicting the future is impossible, so while managing taxes is critical, when does avoiding them at all costs create a bigger investment risk? If you’re holding concentrated stock, contact our team to discuss your situation and explore strategies aligned with your life and goals.