Managing Concentrated Stock Positions and Risk

If you work in the tech industry you're probably familiar with the variety of equity compensation structures many of these companies provide. These forms of equity compensation and the resulting wealth they have provided for thousands of employees has been life-changing. However, one obstacle that often presents itself when a large part of your compensation is derived from your employer's stock is concentrated stock risk.

What Qualifies as Concentrated Stock

There's no particular percentage a single stock position has to carry for it to receive the concentrated stock designation. When evaluating a client's overall investments, net worth and other factors, financial advisors consider the risk one particular position carries as it pertains to the client's ability to achieve their goals. If carrying a single stock position significantly affects your ability to achieve any short-term or long-term goals, you likely have a concentrated stock risk that needs to be addressed.

For example, a Microsoft employee has received several stock grants and subsequent vesting over the course of a decade while also participating in their employee stock purchase plan (ESPP). The resulting financial picture for the employee is $1 million in Microsoft stock and $200,000 in other investments with a total net worth just over $2 million (when accounting for home value). It's clear from this picture that they're carrying a significant amount of risk by holding a single position in Microsoft stock because it makes up almost half of their net worth. Diversifying the Microsoft stock into other industries, sectors, market caps, etc. would reduce the risk and enhance the ability of this person to achieve whatever it is that's important to them.

On the other hand, an early Amazon employee with $1 million in low basis (meaning they received or bought the stock at a low price relative to today) but with an overall net worth of $10 million, likely has the ability to live the life they want regardless of what occurs with the Amazon stock. In this case, they may choose to hold the stock for tax purposes and forward-looking growth prospects, donate to charity, or gift to family.

Concentrated stocks should be viewed from a holistic perspective. What really matters is your ability to live the life you want.

Every individual's situation is different, therefore strategies can differ. However, there are a few common ways to address concentrated stock positions, including selling covered call options, buying put options, using exchange funds, gifting, donating to charity, and, of course, selling the position to diversify. Utilizing a variety of these strategies is typically the best way to manage a concentrated stock position.

Using Options to Hedge

A common strategy employed with concentrated stock is to "hedge" the risk a position will decrease in price by using options. Options give the buyer the right to buy at a specified price and within a specified timeframe. Option sellers, therefore, must agree to sell the position at a specified price and within a specified timeframe if the buyer exercises their right.

If the goal for an individual with a concentrated position is to hedge the downside risk of the stock, they'll want to sell a covered call option or buy a put option. When selling an option, you also collect a premium, which in effect decreases your downside risk by the amount of the premium. When buying a put option, you can hedge a particular percentage of the downside, say 20%. You'd buy enough put options to cover a 20% fall in your stock price. You're limited to losing what you pay for the put options and anything above a 20% fall of the stock.

Using options is effective if you plan on selling off the concentrated stock over a period of time due to tax reasons, or if you fear the market is on the verge of a recession. It can be a complicated strategy to employ if you're unfamiliar with options or have a strict insider trading policy with the concentrated stock in question.

Exchange Funds

Individuals with concentrated stock may consider an exchange fund as a solution. Exchange funds pool investors' concentrated stocks together in a fund to help them diversify their positions and minimize taxes, effectively reducing the risk. The downside is the investor has no liquidity and often pays high fees. There's also no guarantee the investor wouldn't be better off hedging their risk while they sell off the stock position over time, which also would provide liquidity.

Gifting or Donating to Charity

If you've found yourself in the position where your concentrated stock is a "bonus" in regards to your ability to live your best life and achieve all your financial goals, you may consider gifting the stock to family or charity.

It's advantageous for tax purposes to gift highly appreciated and concentrated stock instead of cash or other investments. The receiving person of the gift will inherit your cost basis (the price the stock was purchased at), however, it avoids you having to pay taxes when selling the stock.

If gifting to charity, you'll also receive a reduction in tax liability for that year. Using a donor-advised fund to create a legacy of gifting helps educate and include the family as well. You can all participate in grant decisions and have an impact on the charities you end up donating to.

If gifting to your family is a goal, frontloading a 529 plan for a family member is a great strategy. This type of educational savings account can be used to pay for K-12 private schools or college education expenses. In any given year, you can contribute up to five years' worth of the annual gift tax. That could amount to as much as $75,000 dollars for an individual, or $150,000 for married individuals.

Selling and Diversifying With Other Investments

The most obvious way to reduce the risk of concentrated positions is to sell the stock and diversify it into other investments. The downside is you'll likely owe Uncle Sam a significant sum, especially if it has a low cost basis. Understanding the tax consequences of selling concentrated stock is key in making this decision. Even if it all qualifies as long-term capital gains (20% max tax bracket on the sale), you'll likely push yourself into a higher income tax bracket, which means you end up paying more taxes on your ordinary income as well.

What you do with concentrated stock should be guided by what's truly meaningful to you. Are you able to live the life you want and achieve all your financial goals? If it's necessary to reduce the risk concentrated stock presents to make you more likely to achieve your goals, it should be a priority to do so.

Recent article by Levi Sanchez: Understanding Your Employee Stock Options