Helping clients overcome financial and emotional barriers to diversifying concentrated stock positions.

    The classic "efficient frontier" of modern portfolio theory identifies a concentrated stock position as suboptimal-having too much risk for the expected return or not enough return for the expected risk (see Figure 2.1). Moving to the frontier of opportunity can produce less risk, more return or both, by diversifying the holding. But this theoretical approach to improving investment outcomes often leaves clients cold, with only tepid motivation to overcome the many obstacles to addressing the risks of concentrated wealth. It also leaves them vaguely apprehensive that they might be abandoning the possibility of exceptional returns if that concentrated stock ultimately does very well.
    Comprehensive wealth managers can be especially helpful to clients facing such choices by putting the whole question into context. What resources are necessary to accomplish the client's complete array of goals? Careful analysis of this question permits advisors to judge how much of the client's total financial resources is crucial to achieving those objectives and how much, if any, is in excess of what's really necessary. Any excess wealth can be devoted to expanded goals, to gifts or to investments with degrees of risk that would not be tolerable for the core portfolio.
    Clients with concentrated stock positions are sometimes among those fortunate people who do have excess resources. But when they see, perhaps for the first time, that they can indeed afford concentration risk, some nevertheless begin to wonder why they should continue to take that particular risk. Why not tolerate the permissible risk in some other area-perhaps taking a chance on something more fun or more satisfying, like funding a trendy new restaurant, patronizing a promising young artist, developing a vineyard property, or investing in something that has even greater potential return than is likely for the concentrated stock? Paraphrasing the fundamental message of the investment theory, clients often say things like, "Whew, it's good to know I can afford this risk, but why should I take it for only so-so returns? Let's go all out."
    Most clients, however, even wealthy ones, almost invariably have objectives that will use up all the resources they can muster-and maybe then some. For them, seeing the reality of their need for more reliable investment results provides the imperative for diversification that might otherwise never have captured their attention.
    For either group, then, the first and often easiest step in dealing with the concentrated position is simply to sell it and put the proceeds to work somewhere else. It is often that straightforward.

Overcoming The Tax Constraint
    In the sale of concentrated stock, taxes are most often the chief obstacle to overcome. But even in the worst case, when the owner has zero basis in the asset, the maximum rate of federal tax on long-term capital gain is now 15%, leaving at least 85% of the asset available to invest elsewhere. With any basis, of course, the tax bill comes down and the after-tax proceeds available increase, as shown in Figure 2.2.
    Clients can overcome their aversion to the concept of the tax liability once you focus them on the actual tax burden instead. Many new clients arrive in our office convinced that they can't sell, for fear of taxes, and they're determined not to be dissuaded from that view. Indeed, on several occasions, new clients have announced early on: "You won't get me to sell that position."
    Clients often fear that advisors may be just a bit too professionally detached. After all, we don't bear the tax burden; our clients do. Still, they usually imagine the tax burden to be far worse than it actually is. The capital gains tax burden was once much more onerous than it is today, and some clients can remember an effective rate of 49.125%-just for federal tax on capital gains-in the mid-1970s. Old beliefs die hard. A patient explanation of how small the tax cost is now can be very helpful. Ultimately, most clients can shrug off a tax bill-at least one they consider small enough-especially if you encourage them to do just that.
    But overcoming that psychological barrier is only the first step. The destination for the sale proceeds has to be more appealing than just staying put. That, of course, is the goal of diversification: a greater risk-adjusted, or expected, return for a diversified portfolio than for a concentrated position. In the simplest terms, suppose the concentrated position promises a return of 30% but has only a 25% chance of accomplishing it, and the diversified alternative promises only a 10% return but has a 90% probability of success. For a client who can't afford the risk of the concentration, the diversified alternative seems more appealing (see Figure 2.3).
    But what about those taxes? For example, if your client has only 85% (worst case) of the pretax value to work with, the attraction of diversification appears to get very slim (see Figure 2.4).
    Be careful not to let your clients fall into a conceptual trap here. It is generally not appropriate to compare the return potential of the existing, pretax position with the return potential of the after-tax proceeds of sale. That inappropriate analytical shortcut could lead clients to require the diversified alternative to offer a higher prospective return. The benefit of diversification comes from reducing risk; therefore, the only fair comparison is between risk-adjusted return potentials.
    What's more, the apparent tax disadvantage of the diversified alternative, as small as it might be, is still probably overstated. That's because, barring a step-up in basis at the client's death, that tax burden must eventually occur. The choice is not really between tax and diversified returns versus no tax and concentrated returns, but rather between being taxed now or taxed later.
    Deferring tax is generally a good idea, all other things being equal. But all other things are not equal here. Future tax rates could well be different. Some clients hope for even lower rates, but many fear that rates will be higher. And throughout any period of deferring tax by deferring sale, driven by a client's belief in rates eventually becoming lower, that tax-optimistic client must still bear the higher risk of the concentrated position. You can help your client put this in proper perspective by analyzing how much tax rates would have to decline-and how soon-to justify continuing to bear the concentration risk (see Figure 2.5).
    This analysis can readily test the all-too-common belief that it's worth waiting for basis step-up at death. That belief is simply a matter of expecting the tax rate on the client's holding to decline to zero. Extending the examples in Figure 2.5, that would require, at most, a time frame of twelve years for a risk-adjusted return differential of a mere 1.5%. If the differential in favor of diversification is greater or if the current tax burden is smaller, it takes less time to break even. If your client's death is imminent, postponing sale could be wise. In fact, however, most clients who come to you with concentrated stock positions will be decades away from their final years.
    Consequently, waiting for basis step-up is almost always a flimsy rationale for not selling. It will be even less persuasive if the currently scheduled change in the rules for basis step-up (a limited actual dollar amount of step-up to be assigned to specific assets, not an unlimited, across-the-board benefit) actually goes into effect in 2010. What's more, even today, shares of company stock distributed from certain qualified employer plans don't qualify for basis step-up at all.

Overcoming Psychological Barriers
    Of course, taxes aren't the only problem. Both the legacy effect and anchoring-the emotional or psychological perspectives that keep clients from being consistently rational about their investment-can have a powerful hold.
    Some years ago, a new client presented us with her existing portfolio. The standout holding was a large position in a major local company. "How did you wind up buying so much of that stock?" I asked.
    "I didn't," she explained. "My father was once the company's chief executive officer; he gave me those shares long ago and urged me to hold them. That company and those shares have been part of my life for a long time."
    "But that stock hasn't done much in quite a while, and even the dividend is not that large."
    "Oh, I don't get the dividends; I've had the dividends automatically reinvested from the start. That was my father's idea, too," she proudly announced.
    "How long ago was that?"
    "About twenty-five years; it's really grown a lot."
    Anticipating the nightmare of calculating the actual basis of this holding (the original gift carrying the father's basis and each subsequent dividend buying additional fractional shares over many years), we were tempted to leave bad enough alone. But this client truly needed this part of her portfolio to perform, and the existing holding offered little promise. Our long-range capital adequacy analyses convinced her of the need to sell, but giving herself permission to do so took more than data.
    We explained that her father, long deceased, and his team were no longer in control of the company. The world had moved on, and if her father were still living, his assessment probably would have changed as well. In any event, after all this time, he'd want her to be free to make decisions that were right for her, here and now. The clincher to getting her to sell was a plan to hold back 1,000 shares (including those we couldn't find basis for) to give to her father's favorite charity as a gift in his honor and memory.
    Sometimes the key to convincing the client to decide to sell is a new investment opportunity. For several years, we worked with a client who held numerous directorships in a particular industry and had been CEO of one of the larger firms in that business. He had also been an investor in several broad venture capital investment partnerships. His biggest venture win was a $1 million-plus position in Cisco Systems, with a basis of just a few dollars. Repeated attempts to encourage him to cash in his winnings-even reminding him that the famous venture investors who ran the fund had long since captured their profits and moved on-failed to budge him.
    One day, he was entertaining himself-and us-with his view that his industry was a very good long-term reflector of the growth of the economy, with little downside risk because of its strong and always durable consumer demand. "Owning four or five of the main companies in this industry really can't go wrong as a long-term portfolio strategy," he opined.
    We had our opening.
    "Okay, then, why don't we take your Cisco position and sell it to put your money where your belief is? What do you know about Cisco or its opportunities and risks that many, many others don't know better? You do know a lot about your own industry; let's buy that instead." We did, the next day. Once his initial reluctance to selling Cisco was overcome, we had permanently crossed his diversification boundary. Within the next six months, we were able to further diversify those still-large replacement positions with no continuing objection.

ESOP Sales
    A special case of managing concentrated stock ownership can apply to a privately owned company. Under current tax provisions (Internal Revenue Code Section 1042), the owners of a closely held company can sell part or all of their interest to a special qualified plan-called an employee stock ownership plan (ESOP)-for the benefit of their employees. This strategy can provide several benefits, including tax-deferred earnings for the employees as well as tax-deferred gains for the initial owners who are selling.
    As long as the seller's proceeds are reinvested in U.S. securities within two years, taxes on that sale are deferred, possibly for many years, until those replacement assets are themselves sold. To achieve the benefits of diversification for those proceeds-without concern over capital gains taxes each time a transaction in the diversified portfolio might be necessary-we've used very long-term, noncallable, high-quality corporate bonds as the replacement property for the former closely held business asset. That fixed-income replacement property may not provide the potential for lower risk and higher return that your client is looking for. But long-term, noncallable bonds can be collateral for margin borrowing (see chapter 12). The proceeds of that margin can be used to purchase investments with higher return potential, such as a diversified equity portfolio. The client is then free to later sell those diversified assets without triggering the large deferred gains from the initial ESOP sale. Those gains are housed in the fixed-income assets purchased as the replacement for the company ownership. There is no expectation of transacting in those high-quality, long-term, noncallable bonds for perhaps decades to come.

Let's Just Sell It
So, it turns out, simply selling the position is often the best answer. The next several chapters deal with special considerations for corporate employees, especially senior executives, who commonly face the concentration problem. For them, just selling is often not simple at all.

From Managing Concentrated Stock Wealth: An Advisor's Guide to Customized Solutions, copyright 2005 by Tim Kochis. Published by arrangement with Bloomberg Press. Available at book stores, at, or by calling 1-800-869-1231.