How to Protect Yourself If You Have a Concentrated Stock Position

March 28, 2024

In this episode of FIN-LYT by EWA, Matt Blocki and Jamison Smith discuss how individuals with highly concentrated stock positions can take proactive steps to protect themselves. Concentrated stocks are more common than ever, with many individuals finding a significant portion of their net worth tied to company stock, whether through executive compensation packages in tech and manufacturing sectors or large investments in rapidly appreciating stocks.

Matt and Jamison explore the intricacies of this topic against the backdrop of a rapidly changing economic landscape, where the lifespan of companies has drastically shortened, and the average tenure of an S&P 500 company has significantly decreased. They discuss the inherent risks of holding individual stocks within a financial plan, bolstered by insights from a McKinsey study on the shrinking lifespan of companies due to technological advancements and market dynamics.

The episode will also cover specific strategies for mitigating risk and optimizing financial planning around concentrated stocks, including the use of exchange funds, direct indexing, and options like protective puts and collars. Whether you’re an executive with significant company stock or an investor with large stock holdings, this episode will provide you with the insights needed to protect and grow your wealth in an ever-changing financial landscape.

Episode Transcript

Welcome to EWA’s Finlit podcast. EWA is a fee only RAA, based out of Pittsburgh, Pennsylvania. We hope all listeners of this podcast will benefit as we deep dive into complex financial topics that we will make simplified for you. And we hope that this really serves as a catalyst so that you can make the best financial planning decisions for your family and also save time. Welcome, everyone, to this week’s episode on Finlet by EWa, joined here by Jameson Smith. And we’re going to tackle the topic of how to protect concentrated stocks and different options of how to protect concentrated stock. I find this is more common than ever now with a lot of either whether it’s executives at tech companies or even big manufacturing companies, a lot of their pay and net worth is tied up in company stock.


And then also recently we found some people have made big investments in stocks that have just taken off. So now the question is, do they keep that or do they sell it, pay taxes, diversify it. So in today’s podcast, James and I are going to talk through several strategies of how to manage the risk of a concentrated stock. So first, let’s talk through Jameson. There’s this, actually, we just did a short video on this of the Russell 3000 index. But talk to us some of, about the risk of just holding an individual stock in the context of a financial plan.


Yeah, we can go through that as well. But there’s a McKinsey study, super interesting. We don’t need to get super into weeds of it. Basic high level is like with how fast technology has changed in the last 20 years. The lifespan of companies is just shrinking drastically. So I pulled a couple of stats, and this just shows the risk of investing in one single company. The average lifespan of an S and P 500 company in 2000 was 85 years. So that’s not time in the SP. That is like lifespan of the entire company before 2000. Yeah, in 2000, looking back. Yeah, looking back. And then in 2018, that’s down to 33 years. And then the average time in the S and P 500 now is about twelve years. And then is also down in the past much higher than that.


So bottom line, the whole point of this McKinsey study is the reason is because of how quick industries are changing, technology is advancing, and companies so quickly can become obsolete or no longer be like the front runner in their industry.


Acquired, merged, bankrupt, whatever it is. Yeah, that’s a good point. So let’s just look at some actual data. So Russell 3000 represents large cap, mid cap, small cap, all us companies, 3000 companies. If you had put ten grand in here in 1987, before the crash of 2022, you’d have over $400,000. So 10,000 turned into 400,000. However, if you look at, that’s just. If you put 10,000 in, the index never changed. It just went with the index over those years. However, if you look inside the index, only 34% of those companies outperform the index itself. So about a third, 27% of the companies, underperform the index, and then 39% of the companies not only underperform, but actually lost money.


So if you put in 10,000 to a third of the wrong companies, instead of having 400 grand, you’d have less than ten grand at the end. And some examples of that are like Sears, Yahoo. Some big companies. There’s so many. So the reality is we never try to just to go back into stock picking versus index and picking even those that actively try to beat the index, even in a diversified manner. Less than 5% of mutual funds are able to do that in the US space. If you look at 25 year periods or above, now, half of them can do it in one year periods, but if you look at a long term investment plan, less than 5%. So indexing is really important.


And if you stock pick, you’re a mutual fund because you’re trying to beat the index overall, and the probability of you doing that consistently over time is almost impossible.


That’s a really good point. Mutual fund managers, that is their full time job. They make a lot of money, and 5% of them outperform the indexes. Unless that is your full time job, which is probably not, you probably have another job. You’re not as experienced or knowledgeable as the mutual fund manager. Why do you think you can outperform them?


Yeah, life is so tricky because you can have little wins, little good things you do along the way. And then one mistake, I think a Warren Buffett quote is like one bad thing could ruin your reputation for life. So investing is the same way. Like, you have a million, you’ve turned it into ten, you turn it into 20. Well, a 50% drop now you’re back down to half, and you need 100% recovery just to get back from that 50% drop. So 20 cut in half is ten, and 50% of that back up is only 15. So the wins are important, but it’s more important. I think, once you have solidified wealth and have the disciplined habits to protect it.


Yeah, I think it might have been that. Morgan housel book one bad decision away from going to jail for the rest of your life. Same type of thing.


Same thing with investing.


Yeah. One decision and you’re in jail. Not actually, figuratively.


Yeah. And that’s a good analogy. Just to get a quick tangent, I think it was Tim Ferriss did a podcast, the jail cell, and interviewed these people. And the people, their lifetime sentences had been in jail for years and years. And so they just sounded like normal. They actually sounded like a lot of them, like really good perspective because they had all this time to kind of think, and they were just describing just one moment, essentially. And so with investing, it takes so much discipline to avoid the noise, to have that one moment of that, because it can be fun. Fun. We’re riding, we’re beating, we’re talking, and then you have to realize, what was the purpose of the money? Well, if the purpose of the money, I find is on default, it’s like competition.


It’s like beat your friends, get the nicest car, get the nice, impress everybody, beat the index, have fancy investments that no one else has, when the reality is when you have time to really think, it’s like, why am I trying to spend money to impress people? I don’t even like to live a life that’s not even my life that I’ve chosen for myself. So if you’re really a financial plan, flip it on its head and say, you know what? I just want all my money simply supporting my chosen values, my chosen life by design. And if you make that definition or make that the goal, then the decisions around this just become extremely obvious of choices to make. And that’s if you take the long term smart view, if you just are grinding every day and stuck in that hamster wheel of competition.




Yeah, hedonic treadmill. Then stock picking is going to be what you do, and it could work out in short term periods, and then it’s going to be catastrophic in the long term.




Okay, so let’s talk about, some people will say, okay, this is all great. It’s very common. We see 80% to 90% of executives. For example, their net worth is tied up into company stock, and here’s how. So if you think of an executive making half a million bucks of cash, and then typically they’re making an extra half a million with, like, bonuses or rsus, the 401K limits. If you’re under 50, it’s basically you can put away 5% of your salary. And most people, we say you have to save 15% to 25% to get financial on track. And then these rsus hit and what? RSU is a restricted stock unit. They invest over three years. So basically the company is saying like, jameson, your value. We don’t want you to leave. If you leave, there’s going to be tons of money on the table.


We get to keep and take back. And then you go through these periods where you’ve inside information, you can’t sell them. And then there’s political ramifications because you’re talking to all your other, the C suite or whatever, and you’re like, you look bad if you sell it because it’s like you don’t have conviction in the company.


What are you doing if you have enough exposure? It’s like public information, right? You see all the time, you see these ceos selling a bunch of stock, and then people get all worried.


Yeah, they doesn’t have conviction. So I think the reality is these are very tough. It’s just not as simple as saying, oh, that’s great, I should sell my stock and put it into next one. Sometimes it has to be a slow, well thought out strategy. So let’s talk about the four to five strategies we have. So the first thing you can do, assuming that you do have the capability of selling it, is what’s called an exchange fund. So an exchange fund is really simple. If you have a stock in the SP that’s held in the S and P 500 index, for example, like Apple or Google, Amazon, et cetera, you can exchange like, if you have a million dollars of Apple stock, you can take that and exchange it for a million dollars of the S and P 500 index.


An advantage of this is simply taxes. So if your basis in that million dollars of Apple is 100 grand, and you say, I want to sell it, and then diversify back into, well, you’re going to pay taxes if you’re in the top tax rate, 23.8% federal, that $900,000 gain. But if you do the exchange fund, you keep your cost basis, but that allows you to delay the taxes until you retire or when you unwind it, which hypothetically, maybe you’re in a lower tax bracket, it gives you the control from a tax perspective now, and it also allows you to then get your diversification goals on track. So it’s kind of similar to like a 1031 exchange in real estate. Like you’re just taking one thing, exchanging it for the other.


But this is like you’re taking one stock and exchanging it for 500 stocks wrapped around in the index fund. So that’s the easiest one. Really simple. That would be necessary potentially, if you’re in a non qualified account and you want to not avoid the taxes, but delay the taxes. The second is around direct indexing. So we’re big believers in direct indexing. Direct indexing is you hold the stocks, but instead of holding an index fund that holds the stocks, you just hold the stocks directly and you’re trying to achieve the same exact performance, same exact diversification, same exact risk profile of the index fund within a very low tracking error. The advantage of this is two things. One, tax benefits.


You control what’s sold or bought, and you can 30 days sell something, exchange it, not be out of the market, but 30 days later go back in. Then you have that loss that you can realize one for one against any gains in the future. However, when you have a big stock, if you put that as a central part of a direct index portfolio, the technology will recognize that you want to keep that holding and build the portfolio. Let’s say you’re trying to meet the SP 500 and you have Apple stock. Well, it’s going to build the stock recommendations around that core holding to minimize the tracking error. Now, if you have that big of a holding of a million and you only have a million dollars of cash, you’re investing around it.


Your tracking error is not going to be perfect if you just had the money to go straight in there from the get go. But that is a way to lower correlation and diversify around a concentrated position. If you direct index around that stock. Any further thoughts on that?


No, I think it’s a no brainer for a way to get some diversification and begin tax loss harvesting for future derisk.


And then also just, I know you’ve worked on this several times, so we’ve had a concentrate stock, and then you’ll slowly unwind that. So explain how that works.


So I guess we’ll use your example of like, let’s say you have a million dollars of apple stock with a $500,000 basis. So you have $500,000 gain. Then you’re taking a million bucks of cash, and we’re direct indexing. So forget everything we just talked about risk. And from a tax standpoint, we’ll begin actively tax loss harvesting that million dollars that’s in all the stocks. And so we may lock in $100,000 of losses through the next twelve months with the direct indexing portion.


And real quick, in 2023, let’s say that you’re mirroring the SB 500. You’re going up at 25% or whatever it did. When you say the losses, your portfolio is still going up. A million. Still going up, but to 1.25 million. But behind the scenes, you’re exchanging. And so those unrealized, or those realized losses which aren’t affecting your performance because you’re immediately buying a similar company. I just wanted to clarify that. Yeah.


So then you take, twelve months later, we have 100,000 of losses. And now we chew off 100,000 of the Apple stock, realize 100,000 of gains, you don’t pay any taxes. Now we’re diversified out, and that goes right into the direct indexing portion.


And now we have 900 left of Apple in the next year. We do that, and slowly. So that’s a tax neutral way for you to get out of it. And then also increase your basis. Because the higher your basis is entering retirement, taxes will be irrelevant. Because when you take basis out, there’s no taxes. Money you’ve already paid taxes on. Okay, that’s awesome. So that’s direct indexing. The other option would be, which might be my least favorite, is like a stop loss. So this sounds great. It’s basically like, if you have a stock that’s $100, say, oh, I’ll just put a stop loss on it. So if it drops below 10%, if it drops below 90, it’s automatically going to sell. Well, if you look at any stock that’s worth holding, like, the standard deviation is probably 15, 2030.


So on a given year, it’s going to go.


You can do that in a day?


It could do that one day down 15. And then if you’re not right there, it’s sold. Now what do we do? Well, I think I still like the company. Let’s rebuy it. It’s going to be so irritating, so tax inefficient. It’s not going to really do anything long term. It’s more of like a feel good band aid that’s going to tear in half. It’s not going to protect you.


The only time I’ve seen this successful is if you make a decision up front. I’ve done this with clients. If it hits 20%, whatever the number is, it goes down 20%. We’re making the decision right now. We’re selling it and diversify.


Or on the upside, too.


Yeah, or the upside. And the decision is made right now, and we’re not.


Once it’s done and we’re getting out of it for you. No, I agree. Okay. So the more complicated stuff will be around options. And so there are ways, if you have a concentrated position to put options around it. So I think from a financial planning, there’s many different options.


You can do hundreds and hundreds of.


Yeah, but what I think makes most sense is if the stock has a lot of market share for options available, then a caller is a great option. If the stock doesn’t have as good of a market, then potentially a protective put. But just to keep the math really simple, let’s say we have a million dollars of stock, we want to protect it, but also participate. Basically, if you do two options on the upside and downside and you’re selling some, buying some, so it’s going to be cost neutral. Essentially what you’re trying to achieve is, okay, if the stock drops below ten, that’s my max loss. So if the million dollars goes to one dollars, I’m guaranteed 900,000 no matter what. But then on the upside, I’m locking my gains in at 20. If it goes from a million to 1.2 million, I’m participating.


But if it goes from 1 million to 2 million, I’m only participating up to 1.2 million. So give us a little bit more detail about that caller and option for someone that has run up huge gains. And now we’re still questioning on should we sell this, should we not?


So to dumb that down a little bit more. Again, the objective for financial planning is let’s limit the downside. The stock’s been on. You’ve gained a lot of money from it. Now we need to diversify, limit the downside because if it goes down, you’re in trouble. So the easiest way to do that is a protective put. You’re essentially buying an insurance policy on the stock. And so let’s say the stocks using round numbers make this super easy, is trading at $1,000 a share and you buy a protective put at $800 a share. Once it goes below $800 a share, you have the option to sell it for 800. So if it goes down to 700, you’re selling for 800 and you’re limiting your losses. The downside to that is it’s super expensive. You’re going to pay like 10% of the value in that premium.


So you may pay $100,000 a year to buy that insurance policy. So the caller strategy basically allows you to sell a call option, which is the upside potential. You’re capping the upside. So if it’s $1,000 a share, you’re selling a call at 1200. Somebody’s paying you income for that call option and so you can use that income to offset the premium that you’re paying on the downside for the insurance policy. And like you said, we can make those neutral so it doesn’t cost anything. And if it goes up beyond $1,200 a share, the downside is you’re going to miss out on the upside because you have to sell it for 1200 if it’s at $1,500 a share, for example. So we can limit all the downside miss on some of the upside.


But in our opinion, if we’re doing this for financial planning purposes, who cares?


Yes. Let’s just go through a specific example. So Microsoft is one of the biggest companies in the US. So we actually did this one recently. This is like a slide. It’s trading at 415. So basically this year, if you were to say, I want to protect this for the next 18 months, and we want to do this with a collar, there’s basically four things that can happen. So one, if the stock goes up to 18%, if you do it both sides, the stock goes up 18%, you fully participate. If the stock goes up above 18%, you’re losing that appreciation above 18. So the first thing right off the bat, we have to realize is if we’re now, the stock just like went up crazy last year. So do we think it’s above 18? We have no idea.


But from the financial planning context, we don’t care. Again, because what I’m about to get to is we protect the downside. So the key here is if the stock drops below 7.7%, seven point. So, but we’ll just round up to 8% if the thing drops. If you have a million dollars, it goes to $1. Again, not likely it’s Microsoft, but you’re keeping 920 grand no matter what. If the stock stays flat, if it’s just a flat year because of the premiums you’re collecting on the one side, you’re actually going to make a little bit of money. And then the only downside again is if it goes up above 18%. So that’s the. Why would we do that?


If, let’s say a client cannot because of political risk or insider risk, if it’s an executive, but can do options, this would buy us 18 months to not have any catastrophes happen in the portfolio. Let’s say this is 80% of a client’s net worth. It would buy us 18 months of decision making, at least to protect that downside and still participate. If the market does well and has a double digit year, we’re still full of participating. So the options is not something we recommend for like, hey, let’s just do this for the next 30 years and let’s create a distribution strategy of that. It’s very complex and not going to be, this is, in our opinion, a transition plan.


Protect yourself while you’re transitioning out of what’s a substantial part of your net worth and put it in the world of, hey, I want my money to act by life, by design, and support my life by design. This is a great strategy to transition until you’re fully diversified. Any other thoughts on the options?


No, I would say it’s just important to realize don’t go try to learn options and trade them for fun or to make a bunch of money. This is for a super specific situation to limit downside. There is a lot of risk and if you don’t know what you’re doing, steer clear.


Yeah, absolutely. Any other general thoughts before we close the podcast on what have you seen as the biggest objections of why clients have said, I know, but the stock is going to go higher. I just want to. Wait, what are the biggest objections you’ve seen? And no names obviously, but let’s talk about some specific examples.


Yeah, I think a lot of people that they feel tied to the company if they work there, like you said, if they’re an executive and they’re involved in the decision making, they think that I’m involved in moving this business forward. So why would I not believe in it? Which is true. But I always like to say too, a publicly traded company. Yeah, there’s fundamental analysis and there’s balance sheet calculations and stuff that goes into it. But at the end of the day, a publicly traded company is the perception of the public. So something could happen that gives bad perception, that has nothing to do with the fundamental analysis and the stock price get cut in half or something.


So stupid risk is what we don’t know. Yeah, right. Knowing it’s something that’s not happened before. So one other thing I’m going to say is I think it’s really important to be able to reverse some of those. We’ll call them head trash or whatever you want to call it, limiting beliefs, whatever you want to call it. So if you’re an executive of like, hey, this is going to look bad conviction politically. Well, I believe the best way, because as an executive, the reality is you’re making big decisions every day that could potentially make or break the trajectory of the company. So the best way for you to have the headspace to make the best decisions is to take care of yourself at home.


And the best way to take care of yourself at home is from a financial perspective, is make sure all your goals are on track. Whether that’s funding your kids college, whether that’s making sure you’re financially independent, that will make you ten x better at the workplace in making good decisions. If you’re at the workplace and your entire family future is also dependent on the future of this one company, I think, one, there’s probably some conflicts there, but two, stress is not conducive to good decision making. Lowering stress creates the brainwaves to make awesome decision making. So I think there’s a strong correlation with.


Yeah, totally.


This decision, getting this stress, getting this risk off the plate, where your performance will go way up, actually. So it’s the exact opposite of the conviction. No, hey, I want to do the best for this company. That’s why I’m selling the stock.


Yeah, totally. And getting people to understand, almost like first principle thinking. If your goals are financial independence at 60 kids, education, whatever it is, let’s use that as the framework then to make decisions. Well, you need $3 million to do that and you have another 5 million in the stock. Let’s at least secure and diversify what you need to support your goals. And then beyond that, we wouldn’t recommend that much exposure, but at least we’re securing everything that you’re telling us is most important. And we’re not having that company or something to relying on the company’s profits to put your kids through college, essentially, we don’t want to do that.


Yeah. One other closing thought, someone struggling with decision making is, let’s just say that you have a net worth of $3 million and you’re still going to work, but you’re set. Like your lifestyle, everything you want, your kids already funded through school, you’re five years away from retirement and you want to spend 15 grand a month. And social Security net of taxes between you and your spouse are giving you five. The portfolio net of tax is going to give you that ten, and we’re going to be able to adjust that up with inflation every year. So 15 a month, like you’re set. So the question is, well on the upside, and I asked this question, I said, what happens if you go from three to six? How would your life change?


And maybe one out of ten times I hear good answers, like, oh, well, we would do. We want to gift to kids, we want to gift to charity, we want to buy a house in, we want to be snowbirds, we want to have a house in Pittsburgh and Florida. 90% of the time I get blank stares and say, I don’t know. My life wouldn’t change. Well, then why are we taking the risk? Because then the next question is, what happens if your net worth got cut in half? Would you be okay off of ten a month? And they would say, absolutely not. Why are we discussing this further then? Because we can lock in your life forever and you’re still going to work. So, by the way, we could still get the 20 or 25 month because I know you.


I know you’re still going to work. And that’s your situation today. Why are we taking these chips off the table? Because you’re not gambling the stock. You’re gambling your life and the security of your life and your spouse, et cetera. So I think a lot of times it’s good to put guardrails in place with decision making. Because if not again, day to day to day, you’re the average of the five people surround yourself and you’re hanging out with other people at your company. They’re just talking about good, and the stock price is going to do the x or y, probably not going to make good decisions for yourself or your family personally at home, if that’s all you’re thinking about.


So guardrails and taking the long term and having the accountability advisor I found is often needed to make these big decisions.


Yeah, good question.


Well, James, thanks for joining and we’ll look forward to catching everyone next week. Thanks for tuning in to our podcast. Hopefully you found this helpful. Really hope this is as beneficial and impactful to as many people across the nation as possible. So hit the follow button, make sure to rate the podcast, and please share with any friends or family members that would also find this beneficial. Thank you very much.

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