The plunge in Facebook (ticker: FB) shares on July 26 cost CEO Mark Zuckerberg nearly $16 billion. Zuckerberg still has an estimated net worth of $70 billion, so few tears were shed on his behalf.
Although many employees have benefited from Facebook’s success, the sudden drop in Facebook stock is a reminder of the hazards of failing to diversify a concentrated stock position. Stock options, restricted stock and employee stock purchase plans provide the opportunity to share in company success, and for many employees, employer stock and options dominate their investment portfolio. That concentration in a single stock isn’t necessarily a good thing.
[See: 10 Investing Tips for Busy People.]
Employees at many companies have learned this lesson the hard way. When Enron, Lehman Brothers and Bear Stearns collapsed, many employees lost their savings, jobs and insurance coverage at the same time. In other noteworthy cases, employees experienced a more gradual loss of accumulated savings.
For example, General Electric Co. ( GE) was an original member of the Dow Jones industrial average and boasted the highest global equity market capitalization as recently as 2004. GE executives and employees were significant owners of GE stock. However, GE has lost about two-thirds of its value since 2007. Despite the long-term downtrend, GE stock still represented more than one-third of the company 401(k) in 2016.
The illusion of control, the tendency for people to overestimate their ability to control events, is a common behavioral theme that arises when discussing concentrated stock positions. Although CEOs and company insiders often believe they have unique insight and influence, the Enron, Lehman, Bear Stearns and GE examples illustrate the perils associated with the illusion of control.
Many advisors suggest capping company stock ownership to between 10 and 15 percent of portfolio value. Investors often own stock positions with significant unrealized capital gains, and may feel locked in because of the tax implications of selling.
Although the most obvious solution is to sell enough stock to reduce the concentration to the 10 to 15 percent level recommended by most advisors, the obvious solution may create an unacceptable amount of capital gains. Given potentially onerous tax consequences, many investors chose to spread their sales out over multiple tax years. Some investors make meaningful charitable gifts each year; donating appreciated stock or contributing appreciated stock to a donor advised fund may be a viable option for reducing the concentrated stock position and obtaining a charitable deduction.
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Some investors employ strategies designed to create tax losses to offset the gains created by sale of appreciated stock holdings. Until recently, tax-loss harvesting strategies were a niche strategy used by very wealthy investors. Advances in technology and the emergence of robo advisors have made tax-loss harvesting more of a mainstream strategy. Tax-loss harvesting strategies are typically funded with cash, sometimes with the proceeds from an initial sale of a portion of the concentrated holding. The resultant portfolio of individual equities or ETFs is designed to track a broadly diversified benchmark index.
Tax-loss harvesting involves selling losing positions in a taxable investment portfolio and using those capital losses to offset gains from selling the concentrated position. This technique may reduce the tax impact of selling a portion of the concentrated holding, and can accelerate the transition to a more diversified portfolio. The strategy takes advantage of the natural movement of stock prices, identifying losses among portfolio holdings and selling those positions to capture the loss. As stocks are sold, replacement securities are purchased so as to maintain the portfolio’s risk positioning relative to the benchmark.
For example, it’s common to replace securities of similar companies for one another, such as the Coca-Cola Co. ( KO) for Pepsico ( PEP) Exxon Mobil Corp. ( XOM) for Chevron Corp. ( CVX) or J.P. Morgan Chase & Co. ( JPM) for Citigroup ( CITI). Risk models help to identify less obvious substitutions, but these intuitive examples show the risk management approach inherent in the strategy. Realized losses generated by the strategy are intended to be used to offset gains realized from sales of the concentrated stock position, thereby easing the tax pain associated with the transition.
[See: 7 Things That Could Trigger a Stock Market Crash.]
Owning company stock is a great way to show commitment to an employer and have skin in the game with the company. However, it is possible to have too much of a good thing. A strategy to reduce concentrated stock positions can reduce risk and help investors sleep better at night.
Disclosures: Registration with the SEC should not be construed as an endorsement or an indicator of investment skill, acumen or experience. Investments in securities are not insured, protected or guaranteed and may result in loss of income and/or principal. Unless stated otherwise, any mention of specific securities or investments is for hypothetical and illustrative purposes only. Advisor’s clients may or may not hold the securities discussed in their portfolios. Advisor makes no representations that any of the securities discussed have been or will be profitable.
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Beware Owning Too Much Company Stock originally appeared on usnews.com
