Concentrated Stock: Barriers, Biases, & Strategies

Company stock compensation plans are a great way for companies to reward and retain their employees. Restricted stock units (RSUs) are one of the more common forms of this type of compensation. RSUs are granted to an employee and generally vest over specific lengths of time. The longer the employee stays with the company, generally, the more RSUs the employee receives. Individuals who are fortunate enough to receive these benefits should develop a strategy to ensure that they do not become overly concentrated in a single stock position.

Diversification is a risk management strategy that mixes different asset classes and investments to limit a single asset’s risk. A general rule of thumb suggests that no more than 5 – 10% of your net worth should be invested in a single security. While there are exceptions, this rule will help guide your investment strategy.

The below information explores barriers and biases that exist in converting a concentrated position to a diversified portfolio.

Barriers to Diversification

EXTERNAL

Taxes: Selling large positions of stock can create a large tax liability. Ordinary income tax is due once the stock vests. After the initial tax, gains will be subject to capital gains rates.

SEC Restrictions: Limited to only sell/trade the positions during specific trading windows. Executives may be tied to additional restrictions.

Public Perception: Executives of publicly traded companies and owners of more than 10% of issued company stock are required to report their transactions. The public may view selling company stock negatively.

INTERNAL

Behavioral Biases: Company loyalty may make it difficult to sell the position. Employee may feel like they have control since they have specific knowledge of the company. This control creates a bias against diversification.

Fear of Missing out (FOMO): Fear of missing out on future stock appreciation is a large factor why individuals choose to delay the sale of company stock.

Below are a few strategies to manage risk in overly concentrated stock positions.

Risk Management Strategies

Sell Position: Liquidating the position and reinvest the proceeds into a diversified portfolio. Analyze which positions are most tax efficient and sell across tax years.

Sell at Vest Date: From a tax perspective this is the most efficient. Once the stock vests and ordinary income tax is paid, liquidate the position to diversify. This will often lead to a tax neutral event or minimal capital gains.

Staged Selling: Systematically selling stock over several years. This allows investors to maintain their stock position, retaining the potential upside which achieving the goal of diversification. Staged selling has the ability to spread the capital gains tax liability across multiple tax years, assuming rates stay the same.

Rule 10b5-1: A variation of staged selling. This allows company executives to make predetermined trades while complying with insider trading laws. The price, amount and sell dates must be determined in advance.

Hedging: Diversification is generally the preferred method, but hedging using stock options can be an effective risk management tool. There are a number of different strategies to mitigate the risk, work with a professional with prior history to develop this strategy.

It is important to develop a strategy and incorporate it into your personal financial plan. Before making any decisions, make sure that you consult your financial advisor or accountant, as there are tax ramifications. At Tompkins Financial Advisors, we work with our clients to develop a strategy that fits your financial plan and risk profile. Please reach out if you have any questions.