5 Effective Ways to Diversify a Concentrated Stock Position

5 Effective Ways to Diversify a Concentrated Stock Position

Is it about time to sell? Consider these lesser-known ways to manage a highly appreciated stock in your portfolio.

If you find yourself in a concentrated stock position, congratulations—you’ve likely done something right! Whether it’s through savvy investing, stock compensation, or simply holding onto a winning bet for years, being heavily invested in a single stock often reflects a track record of adding value to an enterprise as an employee or benefitting from a successful investment.

As your success with a single stock builds, however, your risk and your potential capital gains tax liability grow as well. So what’s the best way to balance the risk with a growth-oriented outlook? Different investors make different decisions, but we want to make sure you have all the options in front of you. This article is a deep dive into how to manage a concentrated stock position, including both potential pitfalls, and the many options you have for diversification — including alternatives to selling and paying taxes upfront.

What is a concentrated position?

A concentrated position is generally considered to be when a single stock or investment represents more than 10% of the assets in your portfolio. While this situation can lead to outsized gains, it also introduces heightened exposure to market volatility, single-company performance, and unpredictable “Black Swan” events where a stock loses most or all of its value within the span of a few weeks or months.

The hidden risks of a concentrated position

Having a concentrated position is often proof that you’ve been on track to build your financial future. Whether you accumulated stock compensation through your job or invested in a high-growth company, you’ve likely built a solid foundation to build from. However, this success, along with the looming capital gains taxes a sale typically incurs, can make it psychologically hard to reduce your position.

The truth is that even the strongest stocks can tumble. As an example, the price of Meta dropped by almost 80% in 2022. And even though its value increased by 149% during the first nine months of 2023, the stock was still down about 13% over those two years.

As an investor with a concentrated position, you have to ask yourself if you are comfortable with that kind of volatility. While true black swan events are uncommon, the regular movement of a single stock can cause some major heartburn — even with strong companies that are generally headed in the right direction:

What diversification can mean for your portfolio

While the risks of holding a concentrated stock are pretty clear, the picture can get a little muddled when you start including capital gains taxes and FOMO in your analysis. Many investors decide that potential future appreciation and the impact of tax drag from realizing capital gains can outweigh the benefits of diversification. However, market data tells a different story most of the time.

Historical analysis has routinely shown that broad market indices tend to outperform individual stocks over time. Past results are no indication of future performance, of course, but we conducted our own research with the high-growth Nasdaq Index, and saw similar results:

In the 20th Century, the Nasdaq-100 has outperformed roughly 75% of individual stocks in the index, with nearly half of those stocks losing value in the long run.

Diversifying your concentrated position typically involves selling a portion of that position and redistributing the proceeds across a broader investment, such as a stock index. However, this approach comes with its own set of challenges—chief among them, the potential for significant capital gains taxes.

5 alternatives to selling your concentrated stocks

Capital gains taxes can cut into returns, but there are several strategies to reduce them without staying married to the risk of a single stock. Here are a few approaches to manage risk without triggering a big upfront tax bill:

1. Exchange funds

Exchange funds offer a way to exchange your concentrated stock for a diversified basket of securities without triggering immediate capital gains taxes. Essentially, you pool your concentrated holdings with those of other investors, creating a more diverse fund by sharing stocks (and risk) with each other.

2. Collar advances (also known as prepaid variable forwards)

These tools can let you borrow against the value of your shares while protecting you against a loss if your shares go down.

3. Direct indexing

Direct indexing lets you build a customized portfolio that mirrors the performance of a stock index while holding the individual stocks directly.

4. Donor-advised funds (DAF)

For charitably inclined investors, donor-advised funds offer a dual benefit: You can donate your appreciated stock, receive an immediate tax deduction, and avoid paying capital gains taxes on the donated shares.

5. Other strategies

Depending on the nature of your concentrated position and your long-term financial outlook you might also consider approaches like:

What’s the strategy for diversifying?

Deciding how to diversify your concentrated stock position isn’t a one-size-fits-all proposition. The right strategy depends on factors like how quickly you want to reduce risk, your need for liquidity, the level of capital required, management costs, and your overall tax situation.