Investors who have done well over the years – whether through savvy stock picks, favorable market returns, or just good luck – often find themselves with a unique set of problems to deal with. After holding stocks for a long period of time and achieving substantial returns, investors may have two unexpected issues to be concerned with: (1) concentration risk and (2) unrealized capital gains.

These are good problems to have – they are signs that you made money! But they are important to monitor and work through carefully to reduce the chance of losing that money and paying more taxes than necessary.

Concentration risk

Investments can be boiled down to two components: risk and return. Investors are willing to take some amount of risk with their money in order to get more money back later. There are many different types of risk, some of which can be avoided and some of which cannot.

Systematic risk is a group of risk factors that may be hedged but not totally avoided. This includes things like market risk (the broad movement of prices due to investor behavior), interest rate risk (the movement of prices due to changing interest rates – e.g., decline of bond prices in 2022), inflation risk (loss of purchasing power – i.e., growth that does not keep up with inflation), and exchange rate risk (due to the fluctuation in values of currencies).

Unsystematic risk (also known as specific risk or concentration risk) is not market-wide – it is unique to each investment or sector of investments and therefore can be reduced through diversification. A portfolio that holds only one or a few stocks is exposed to company-specific risk because the returns are contingent on those companies doing well, rather than the economy (and market) doing well as a whole. Holding a lot of money in just a few stocks means that the portfolio can suffer due to company-specific flaws such as bad actors (e.g., Enron), poor sales and bad management (e.g., General Motors leading up to its bankruptcy in 2009), and reckless risk-taking (e.g., Lehman Brothers).

Concentration risk can be identified by measuring the amount of each stock holding as a percentage of your overall investment assets. A good rule of thumb is that if any one position accounts for more than 10% of your portfolio, that stock can pose a significant and unnecessary risk to your investment returns.

So, if one component of risk (the specific type) can be reduced through diversification, why not sell some of that highly appreciated stock and buy some other investments? Many people avoid making this change because of one glaring obstacle: taxes.

[Author’s note: Another reason some people hold off on selling concentrated stock is due to emotional attachments to their investments. While this will not be covered in this article, it is a very important consideration and often helps inform the decision on how to move forward!]

Highly appreciated stock and taxes

Highly appreciated stock describes shares of an investment that have gained significant value since the time of purchase. If the shares have not yet been sold, they will have unrealized capital gains. 

For example, if you bought 100 shares of ABC company in 2010 for $30,000 and the 100 shares grew to a value of $90,000 by 2024, there would be $60,000 in capital gains. Until the shares are sold, those are unrealized capital gains. Unrealized gains just exist on paper, but as soon as the shares are sold, they become realized gains which may be taxable. 

Realized gains are not taxable in a tax-deferred account such as an IRA or 401(k), so selling stock in those types of accounts can be done without much headache. However, realizing capital gains in an after-tax (or “taxable”) investment account is a taxable event and should be planned for with care. That is the focus of the following information.

Managing concentration risk while being mindful of taxes

If taxes were not a concern, managing concentration risk would be simple. You would just need to sell some or all of the large stock holdings and allocate the proceeds to diversified investments. Since that is often not practical with legacy stocks that have been held for many years, one must be creative to mitigate risk while being mindful of taxes. 

Below are some effective ways of accomplishing this difficult task.

Donor-Advised Fund

A donor-advised fund (DAF) is a charitable investment account that can be set up and managed by an individual investor. This is an excellent strategy for individuals who are already charitably inclined and can benefit from more tax-efficient gifting. Highly appreciated stock can be transferred into the DAF, counted as a current-year charitable gift, and then distributed at the discretion of the owner. Rather than donating after-tax dollars, an individual can donate their highly appreciated stock and invest their dollars in diversified funds instead. The stock can then be sold within the DAF with no tax consequences and invested in a way that aligns with the donor’s charitable goals.

Tax-loss harvesting

Tax-loss harvesting is a strategy in which investments are sold at a loss and the proceeds are used to purchase reasonably similar (but not substantially identical) investments. This allows investors to use realized losses from one position to offset realized gains from the concentrated stock. The proceeds from all sales (the position at a loss and the position at a gain) are immediately used to buy a suitable replacement security, thereby keeping the investor in the market.

Tax-loss harvesting only helps in dealing with highly appreciated stock if some of that stock is at a loss (e.g., most shares are at a gain, but some more recently purchased shares are at a loss) or if the individual holds some other investment that has unrealized losses.

Direct indexing

In direct indexing, investors hold a collection of individual securities (e.g., individual stocks) that together seek to track the returns of a market benchmark (e.g., the S&P 500). This is different from holding an Exchange Traded Fund (ETF) or Mutual Fund that tracks the benchmark index. In direct indexing, the investor holds underlying securities that are contained in the benchmark.

This strategy can be used to offset some of the concentration risk from highly appreciated stock – the direct index can essentially be built around the existing position. For example, someone who holds large positions in Microsoft and Apple may want to invest in the S&P 500 without buying more of Microsoft and Apple (two of the largest stocks in the index). Direct indexing can help with this.

A key component included with direct indexing is tax loss harvesting. Often the holdings will not include every single investment from the underlying benchmark, but rather a collection of underlying investments. These can be strategically sold and swapped out with other positions to harvest tax losses, which then allows for the investor to keep taxes down when selling more of their concentrated position.

An important caveat is that, in order to buy the necessary positions to begin the strategy, the investor must either have cash to invest or commit to selling some of the concentrated position (and realizing gains) at the outset.

Using sector or style funds

This strategy is conceptually similar to direct indexing but simpler to implement. In a broad market index such as the S&P 500, there are often investment funds that contain sub-components of the total index. For example, there are ETFs available for each of the eleven sectors (Energy, Healthcare, Financials, etc.) of the S&P 500. Someone who holds a large amount of Energy stocks could purchase shares of ETFs representing the other ten sectors – in carefully calculated percentages – to round out their overall position and more closely reflect the S&P 500.

Similarly, an investor who holds only the Magnificent Seven stocks may want to purchase an S&P 500 Value ETF (a style fund) to complement their Growth exposure.

Using sector or style funds to balance out a concentrated position will require having some cash or realizing gains at the outset – there must be capital available to invest in the non-concentrated positions. As with direct indexing, there are often tax loss harvesting opportunities with this approach although the frequency and magnitude will be more limited.

Options

Options are a type of derivative security, meaning their value is determined based on the value of an underlying asset (e.g., a stock). The owner of an option contract has the right to either buy or sell (depending on the type of contract) the underlying asset at a specified price, within a specified time frame.

Options are complex and can be used in a number of ways, and to follow are just a few of the strategies worth noting for managing concentration risk.

• One straightforward strategy is to buy put options on the concentrated stock. This involves paying a premium now to buy downside protection in the event the underlying stock price declines.
• Another approach is to sell covered call options on the concentrated stock. This means the stockholder is selling to someone else the right to buy the stock. The investor with the concentrated position receives a premium when the option is sold so this can be an income-generating strategy. However, this limits the upside potential for the concentrated stockholder.
• Finally, a collar can be created to set a protective floor (limiting losses) and also put a ceiling on returns. This combines the two strategies of writing covered calls and buying puts. The premium generated from selling the call options is used to buy put options. The purpose is to allow for limited upside capture while protecting against significant losses, all with zero or minimal net premium expense. All of these strategies must be undertaken with extreme care in order to avoid having to sell the highly appreciated stock if the contracts are executed.

Conclusion

People who often run into the problem of concentration risk may have purchased some great stocks a long time ago, inherited stock a long time ago (and it has appreciated since receiving a step-up in cost basis), or they could be employees who receive significant equity compensation from their employer. For those who receive equity compensation, the risks and tax implications can be even more complex due to the varying tax treatment among different types of equity awards.

Managing highly appreciated stock is a complex undertaking that often requires comprehensive financial and tax planning.

There is no single course of action better than another – it may be best to use multiple strategies, such as those discussed in this article, in conjunction with one another. The best approach will depend on your own goals and circumstances. As the value of the concentrated stock grows (in dollars and as a percentage of your overall investments), the risk of loss increases, as does the tax burden. The more there is at stake, the more prudent it will be to consult a professional for assistance.

[Author’s note: The majority of this piece refers to individual stocks when talking about highly appreciated investments but the same principles can apply to other types of investments such as Exchange Traded Funds and Mutual Funds.]