You may have ended up with too much invested in one stock. Perhaps you sold a closely held business for shares of a publicly traded company. Maybe you received a significant holding of a single security through an inheritance. Or you may get stock shares in a company you work for as part of your compensation package.
Investing in one company—especially if you believe in the company—can be a potential way to amass wealth. But if you want to preserve wealth, diversification can be key, says Sean Lynch, CFA, Managing Director of Equities for Wells Fargo Private Bank.
Owning too much of any one equity can add volatility to your portfolio and leave you exposed to investment risk. Here’s what you need to know about the risk of too much exposure to one stock, plus how to make a plan for diversification.
Need to know: The dual risk of working for and investing in the same company
Corporate executives often end up with a heavy concentration of company stock because they tend to receive a large part of their compensation through stock or stock options, Lynch says. You can also accumulate stock through 401(k) matches and direct purchase plans.
Executives or non-executive employees face a dual risk if their concentrated position is in the stock of the company they work for. Think about it: You may already rely on your employer for a significant portion of your income. If the company experiences a downturn, you can potentially lose your job, your healthcare coverage, and your retirement security—in addition to the drop in value of your portfolio.
Examples that illustrate this dual risk are not hard to find. After the collapse of Enron in 2001, hundreds of employees lost their jobs—and their life savings—because they were heavily invested in company stock. More recently, GE employees suffered substantial losses after GE stock dropped 60 percent between January 2017 and January 2018.
Need to know: The 15 percent rule
So how much exposure is too much? That number depends on how much wealth you build outside the stock market and on your individual financial goals, Lynch says. But if you have more than 15 percent of total exposure in any one stock, Lynch recommends sharing that circumstance with your investment professional and managing the potential risks it could pose as part of your wealth management plan. “You should know why you’re holding it and what you’re going to do with it as well as understand the risks involved,” Lynch says.
Your wealth professional can create a net worth statement and assess your overall exposure to the stock and the industry sector. Then he or she can help you map out a strategy to mitigate concentration risks, keeping in mind any legal and tax implications.
Need to plan: Methods of diversification
To diversify your portfolio, you may decide to sell a portion of your holdings immediately. You might also establish a plan to sell holdings over time.
Although selling an investment generally has tax implications, when capital gains tax rates are low, Lynch says, selling could be a more viable option than in other tax years.
A different—and possibly more tax-efficient way—to diversify is through exchange funds, which allow you to exchange shares of a concentrated position for shares in a diversified fund.
In addition, there are other, more complicated ways to create liquidity and hedge your concentrated position, Lynch says. Ask your investment professional about the pros and cons of these different opportunities.
Need to plan: Timing your diversification
Investors may be reluctant to diversify because they have an emotional attachment to the stock or they are concerned about tax implications. However, Lynch notes that conditions appear favorable for putting a plan into action now.
“We are seeing more volatility in the markets and we also have low tax rates,” he says. “Those conditions make this a great time to have the conversation with your investment professional.”