Managing a portfolio around a concentrated position(s) may be one of the most difficult concepts for investors. A “concentrated position” is an investment holding that represents a disproportionate percentage of a portfolio. Investors who choose to ignore concentrated positions within their portfolios are taking unnecessary risks. Rarely does a concentrated position resolve itself. Instead, investors need to adopt a strategy to systematically alleviate this concentrated risk.
So why do investor’s find it difficult to manage a concentrated position in their portfolio? There are several reasons, but we’ll highlight the most common hurdle investors struggle with in managing these positions – delaying taxes.
Near term justification for holding concentrated position(s) is simple: delaying taxes. Selling a concentrated position(s) results in an immediate tax on any accumulated profits, and for a security with low cost basis, that tax can be significant. Current capital gain rates vary by holding period, with short-term gain rates as high as 39.6% and long-term gain rates as high as 28%. Additionally, there may be additional state and alternative minimum taxes. However, delaying a taxable event as reasonable justification may be pound foolish. Dollars saved today by delaying taxes could potentially cost an investor significantly more in the future. There are three important costs associated with concentrated positions:
- Cost of potential disaster: investments are affected by infinite number of variables: competition, regulation, patent expiration, better mousetraps, etc. Investors face both market risk and company specific risk, and these are impossible to predict consistently. How likely may your concentrated position drop more in value than the taxes you are trying to avoid?
- Cost of changing tax laws: some investors argue they will reduce concentrated position(s) when taxes become less burdensome. However, Since 1916, the capital-gains tax rate has changed more than 25 times, with the highest capital-gains tax rate being 77% in 1918. And while current capital gain rates may seem punitive, especially when factoring in for some investors the additional Net Investment Income Surtax, the uncertainty of changing tax rates must be considered. Given current capital gains tax rates are known, and generally they are significantly favorable to historic data, there is little reason to tolerate the risk of concentrated position in hopes of delaying an inevitable taxable event.
- Cost of lost opportunity: the risk in an investment is more than just the chance of capital loss, there is also the risk of lost opportunity. Holding a concentrated position that underperforms the market year in and year out can be more damaging than gradually reducing the position to a more manageable size, paying the taxes, and reinvesting the sale proceeds within proper guidelines for your portfolio diversification and risk tolerance.
In summary, ignoring the elephant(s) in your portfolio increases the risks of a concentrated position(s) doing more harm to your portfolio in the long run. Investors must implement a strategy to identify these positions, take actions to alleviate this risk, with the goals of managing their portfolios within their risk tolerance to reach their long-term goals. If you have any questions, feel free to post your inquiries on our Facebook page.