With the recent run-up of stock market levels over the past several years, many investors might find one or more of their investment holdings have appreciated considerably in value, now representing a disproportionate percentage by market value. With this in mind, it is important for investors to pay attention to these concentrated investment position(s), an important investment concept that often is over-looked for proper portfolio management.

 

A concentrated position can be defined by different measurements, but commonly can be defined when an investment holding exceeds in market value 10% of the total portfolio value. For investor’s, managing these concentrated positions can be difficult for a variety of reasons, such as having very low tax basis. When such positions are owned in taxable accounts, reducing/selling such positions can result in excessive taxable consequences. Other reasons for allowing a position to become excessive can be due to emotional attachment.

For these reasons among others, many investors often make poor investment decisions associated with their concentrated holdings. Investors with concentrated positions need to adopt a planned process of reducing these position(s), thereby safeguarding their overall portfolio performance. Alternatively, by remaining concentrated in one or more portfolio positions, investors face both market risk and specific risk, where one or more of their concentrated positions decline substantially in market value outside of the investors’ control.

Investors with concentrated positions may like to consider the following questions as to why it is important to take a hands-on approach to manage concentrated positions:

• will future capital gain tax rates be more or less favorable when the concentrated position is reduced/sold in entirety?
• for those investor’s concerned on tax consequences, how likely is the concentrated position more likely to drop in value than the tax consequence trying to avoid?
• what, if any, opportunity cost am I missing out on by leaving the money invested in the concentrated position, rather than finding an alternative investment(s) that could perform better?

To answer these questions, history has shown tax laws are not set in stone and there is no guarantee future capital gains tax rates will be more, or less, favorable. Holding concentrated positions does not avoid paying capital gains taxes, it merely delays the payment, unless the goal is to never sell, and rather, pass concentrated holdings to heirs or charity. In most cases, concentrated positions need to be sold if the rewards are to be realized. Further, the risk in a stock is more than just the chance of a capital loss; there is also the risk of lost opportunity. Holding a stock that underperforms the market year in and year out can be more damaging than holding a stock that falls in value in a short period of time. Concentrated position(s) that are underperforming need to be properly managed in relation to other holdings, while looking for alternatives that can provide outperformance, less specific risk, and better long-term results.

So what can investors do? Adopt a planned process to reduce concentrated positions! The worst approach for a portfolio with one or more concentrated positions is to do nothing. Investors can either address their position and resolve it through careful planning or let outside forces resolve the issue, resulting in market losses, higher taxes, or a combination of both. Provided here is one approach that investors might find helpful:

• define your measurement of a concentrated position;
• organize holdings across all investment accounts to identify any concentrated position(s);
• develop a plan to gradually reduce these concentrated positions over a set time frame, taking into consideration taxable consequences, and opportunity cost;
• find replacement candidates for reinvesting, hoping to find those new investments that provide greater upside, long-term performance.

Investors first need to define what represents a concentrated position for their investment goals. Is it a benchmark of 10% of total invested assets, or another measure that is more appropriate for your risk tolerance and long-term goals? Once determined, investors need to then organize their holdings across all investment accounts (both taxable and nontaxable; spousal, etc.) to identify concentrated position(s) held in aggregate of all accounts. For those concentrated position(s), investors should then adopt a plan to reduce the concentrated position to fall back in line with other investments owned. This might be a multi-year process, reducing by a percentage each year, until the holding is no longer concentrated by the measurement being used. For example, an investor with 20% of his portfolio in a single position could choose to reduce his position size by 6% a year, with 1.5% adjustments made each quarter. This approach allows the investor to use a systematic approach to reduce their concentrated position, while gradually building a new position(s). The spreading out of the buying and selling over multiple periods can potentially minimize the timing risk.

In summary, a plan needs to be put in place, and then acted upon, even if it means just a token first step. The first step is always the most difficult, and subsequent adjustments are often easier to implement. Concentrated positions are significant risks and need to be addressed. The benefits of properly managing these positions clearly outweigh the costs (taxes, opportunity, and emotional) one might incur.

Reference Source: Wachovia Securities LLC “The Elephant in the Room”