Clients ignore concentration risk. Maybe the more common issue, though, is that clients want to throw caution to the wind and hold the options regardless of how high the price goes. Maybe the strike price is $10 and the current price is $70, but the client wants to hold the options—or exercise them and hold the shares. While the mistakes with early exercising and capital gains can be diffused by logic and numbers, this third problem is more challenging, because it’s possible to talk and talk to the client and still come up against a brick wall when he says, “Yeah, I know, but I think the company is going to do great.” But that doesn’t mean advisors should not try. We point out how much of his wealth he would lose if something unforeseen went wrong with the company and how that concentration risk is exacerbated by his having human capital tied up in the company as well.

Concentration risk can also come into play, though less directly, if the client holds incentive stock options and receives preferential tax treatment. (The granting of ISOs has just about disappeared over the past 10 years, says Feraro, though grants from years ago can still show up on clients’ statements.) Here, the client may want to hold the stock for a year after exercising to have the entire spread between the exercise price and sale price taxed as capital gains. However, the client’s loss of that preferential treatment under the alternative minimum tax makes the reality of the situation much more complicated. The AMT credit notwithstanding, it may well be that holding all the shares will ultimately produce no more of a tax advantage than holding a portion of them. An accountant that well understands incentive stock options and the role of the AMT credit will be helpful here.

What happens if the accountant is confident that the tax advantage can be enhanced by holding all the shares? As much as we hate to throw away a substantial tax break, we may find it necessary to recommend doing exactly that if the risk of exposure to one stock is too high. As with most risk/reward balancing acts, the approach will be different for every client, depending on his or her circumstances and emotional makeup. But we all know what exuberance can do, and how employees can become enamored of their company stock.

In such cases, numbers may give way to the cautionary tale. Back in the winter of 2000, I was at a party in Seattle with mostly Microsoft employees. Their company’s stock price was in the mid-90s, down some $25 off its high, enough to get the attention of people who had grown accustomed to a one-way ride. I recall this one man confidently taking a swig from his bottle of beer and waving off the anxiety. I don’t remember his exact words, but it was something to the effect of, “Don’t worry. It’ll turn around, and in six months it’ll split again.”

We all know what happened. By Memorial Day, the stock was in the 60s. By Christmas it had fallen into the 40s.

Paul Palazzo, CFP, COA, is Managing Director of Altfest Personal Wealth Management.

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