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How to Diversify Your Company Stock—Intelligently

Financial Planning & Wealth Strategies

How to Diversify Your Company Stock—Intelligently 

Do you own a lot of your employer’s stock? For many executives, equity is an attractive part of compensation and can offer a lot of upside—but it’s important to remember that it can also bring a significant amount of risk.  

If you don’t believe me, just consider the dot-com crash. For many unlucky executives, this was a profound exercise in concentration risk gone wrong. During this period (which was prior to Stembrook’s formation), I advised numerous clients about diversifying out of company shares, and by and large, they took my advice and made it through the crash in good shape. 

However, many tech entrepreneurs and executives weren’t so lucky. How many stories did we hear about people losing their life savings in that brief but disastrous period?  

I’ve noticed a rising tolerance for highly concentrated positions recently, especially given the importance of incentive compensation plans. And when things are going well, it’s tempting to let your stock position grow unchecked—the more so if you believe in your employer and the work that you’re doing! 

But a failure to plan is planning to fail. If both your investment account and your income are tied to one employer (or even a single sector), you could be adding risk to your life that you can’t afford. 

Here’s what you can do instead.   

Scheduled Sales 

Similar to auto-pay on bills or scheduling with a personal trainer, automating parts of your investment management is a great way to build a more robust system without a lot of willpower or effort. The discipline of scheduled sales takes the emotion out of the decision and helps you make sure it gets done—regardless of whether it’s the “perfect” time to sell. 

This also helps to manage the tax liability of your equity sales, while incrementally moving your assets into a more diversified portfolio. 

Buying the Right to Sell 

A simple “insurance” policy for minimizing the risk of your stock position is to buy put options, which give you the right to sell your shares in the future for a pre-determined price. If the price of your position falls below the “strike price” in the options contract, you can always sell your shares at the strike price to protect yourself against losses. 

The downside to this strategy is that you may keep buying options you don’t use—the costs can add up over time.

Hedging with a Collar

Another options strategy is the use of an “equity collar,” in which you buy a put option, as described above, but also sell a call option (which gives the buyer the right to buy your shares at a pre-determined price sometime in the future). Generally, the options in question will be “long-dated,” meaning they’re longer-term contracts. 

There are different ways to structure equity collars, but oftentimes they’re planned so that the income received from selling the call option cancels out the cost of buying the put option. 

Completion Portfolio

In this case, the holder of a concentrated stock builds a complementary portfolio that might exclude the sector, industry or some other risk factor present in the concentrated stock position. The diversification benefits are often less pronounced, but this approach can remove some of the risk that a concentrated stock holding presents while building a diversified portfolio that can stand the test of time (and potentially be lighter on your wallet).  

Exchange Funds

For executives who want the benefits of diversification without the tax liability of a sale or the complexity of options strategies, exchange funds can be a reasonable solution. These private funds pool the concentrated positions of many positions into a fund, which is then allocated proportionally across the individuals. 

Because these are private placements, such funds place a high eligibility bar on investors in terms of income and net worth. Exchange Funds also tend to carry hefty fees. However, given their ability to provide diversification without tax liability, they can be an interesting solution for the right situation. 

Other Techniques 

Other strategies, including the use of net unrealized appreciation in retirement accounts or borrowing on margin in brokerage accounts, can also be used to meet the goal of tax-efficient diversification. As the technical complexity of these strategies increases, however, it’s critical to remember the importance of prudence—a particular strategy can work very well for one individual but be a waste of time and money for another. 

The point being that a number of variables have to be weighed against each other, including the type and amount of stock you’re holding, the level of concentration risk it brings to your portfolio, your possible tax liabilities, and your other investments and goals.  

Start Here

The first thing you need to consider is how much exposure you have in the first place. This is often hidden away in your HR portal or between accounts, and the addition of vesting schedules can make it hard to get a clear picture. Figuring out the details is the first step. 

We’ve seen this situation many times and have implemented a variety of strategies to deal with it. Give us a call today to learn more about your options.