An executive at Merrill Lynch emphasizes that key to managing the wealth of an investor with concentrated stock is understanding their emotional attachment to it and being realistic about risk.

Most of the world's billionaires became rich off the back of the businesses they created; they or their heirs claim the top ten spots on both the global and US Forbes 400 lists of wealthy people, Merrill Lynch noted in a new report.

Given this, these individuals are likely to hold single stock positions that represent a significant portion of their portfolio. This is also often the case with senior executives and those who have made great investment decisions.

But while owning concentrated stock (typically representing over 30 per cent of an investor's overall holdings) can be a primary driver of growth, it may on the other hand be – or become – the greatest source of risk, such as through increased volatility, potentially large draw-downs and permanent loss of wealth, Merrill Lynch warned.

Equally, as an investor's wealth grows, complex financial issues often arise, and owning concentrated stock can be a contributing factor, the report, entitled Concentrated Stock: Strategies for Continued Success, said. It advocates that addressing an investor's desire for safety and liquidity when managing concentrated stock is crucial, and offers several strategies for managing such a position.

Family Wealth Report asked one of the report's authors, Keith Schnaars, to outline key considersations for advisors that have clients with concentrated stock in their portfolios, as well as other observations related to this subject.

Two broad trends have caused an increase in concentrated stock ownership in the US: the rise in market values since 2009 and the increase in capital gains taxes at both the federal and state tax level, said Schnaars, director and ultra high net worth specialist at the firm. To a lesser extent, wealth creation through initial public offerings and mergers/acquisitions have been drivers, Schnaars noted.

Asked roughly what percentage of Merrill Lynch clients hold concentrated stock in their portfolios, he said this varies: “One reason, market movements; another reason, client perception. What the prudent investor would consider a concentrated stock position is often different from the concentrated shareholder who may deny the risk, or even their needs, and will continue to hold the position. I find that client bias toward a particular company will run very strong for several reasons. These reasons may be allegiance to the company, the company’s products, or they or a family member who worked for the company.”

Strategies

While some investors believe their single stock will continue to strongly outperform the market – and may be comfortable with volatility along the way – others may prefer to cut or liquidate their positions, but in the end decide not to. Reasons for this could include regulatory issues, tax implications or behavioral biases, the report said.

Schnaars' advice to advisors who have clients with concentrated stock is to talk openly and honestly about these positions, particularly if they represent financial risk currently or potentially in the future.

“Although the concentrated position may have created wealth, without proper management, that wealth may dissipate,” he said. “The best skill [required] in addressing those concentrated positions relates to the client’s emotions about those positions. Without understanding the client’s attachment to the stock, an advisor risks alienating the client on several levels.”

The ideal strategy for any client in this context should be determined by examining both their near and long-term goals, and how they relate with each other, Schnaars said, offering the following example: “If one client may have a need for cash flow and charitable intent, then a charitable remainder trust may be a solution. However, another client may want to minimize risk in the near term and act on the concentrated position at a later date; for that client a derivative based strategy would be suitable.”

Other strategies considered in the report include: stock sales; loaning on stock; selling covered calls or lending stock to short-selling traders; converting stock to cash using prepaid forwards or premium forward sales; gifting stock or donating it to a charitable organization or foundation; trading highly appreciated, low-cost basis stock positions for shares in a diversified exchange fund; and protection through puts, calls and collars.

While each of these carry their own benefits and drawbacks, they should of course be implemented in the context of an investor's goals and financial circumstances. For example, while selling stock can create liquidity, and is a form of risk management and diversification, issues to consider include taxation and the potential impact of such a move on the market if dealing with significant positions. With protection strategies, a form of risk management, there is a cost aspect to consider as well as relative illiquidity, counter-party risk and collateral requirements. Also, company executives and insiders may be subject to trading restrictions, the paper noted.

“Managing concentrated stock positions is critical to ensuring that investors' needs are met through effective use of the wealth in their portfolios,” Merrill Lynch said. “Concentration may be effective in helping investors realize their aspirations by providing returns that, in most cases, are not available through a well-diversified market portfolio.” However, a concentrated stock position can also create some serious risks if an investors' needs and emotions are not properly assessed and managed, it warned.

“Let me give you a success story,” Schnaars said. “We have a client who did not want to liquidate a stock position in spite of the fact the position grew in value by many multiples over many years. Also, the client continued to hold the shares in certificate form for over 30 years. The client’s reason: her grandfather gave her the stock certificate. We were able to negotiate with the transfer agent to have the cancelled certificate returned to the client... This allowed our client to hold on to the icon of the memory, while permitting appropriate diversification.”