5 Effective Ways to Diversify a Concentrated Stock Position

If you find yourself in a concentrated stock position, congratulations—you’ve likely done something right! Whether it’s through savvy investing, stock compensation, or simply holding onto a winning bet for years, being heavily invested in a single stock often reflects a track record of adding value to an enterprise as an employee or benefitting from a successful investment.. 

As your success with a single stock builds, however, your risk and your potential capital gains tax liability grow as well. So what’s the best way to balance the risk with a growth-oriented outlook? Different investors make different decisions, but we want to make sure you have all the options in front of you.This article is a deep dive into how to manage a concentrated stock position, including both potential pitfalls, and the many options you have for diversification — including alternatives to selling and paying taxes upfront.

What is a concentrated position?

A concentrated position is generally considered to be when a single stock or investment represents more than 10% of the assets in your portfolio. While this situation can lead to outsized gains, it also introduces heightened exposure to market volatility, single-company performance, and unpredictable “Black Swan” events where a stock loses most or all of its value within the span of a few weeks or months.

The hidden risks of a concentrated position

Having a concentrated position is often proof that you’ve been on track to build your financial future. Whether you accumulated stock compensation through your job or invested in a high-growth company, you’ve likely built a solid foundation to build from. However, this success, along with the looming capital gains taxes a sale typically incurs, can make it psychologically hard to reduce your position. 

The truth is that even the strongest stocks can tumble. As an example, the price of Meta dropped by almost 80% in 2022. And even though its value increased by 149% during the first nine months of 2023, the stock was still down about 13% over those two years. 

As an investor with a concentrated position, you have to ask yourself if you are comfortable with that kind of volatility. While true black swan events are uncommon, the regular movement of a single stock can cause some major heartburn — even with strong companies that are generally headed in the right direction:

The volatility of five blue-chip stocks

The performance for Microsoft, Costco, Amazon, Apple, and PepsiCo from September 2021 through September 2023. All of these stocks experienced at least four 10% declines during this two-year period. Source: Bloomberg. Provided for illustrative purposes only, not a recommendation to buy or sell any security. 

It’s not just about broader market volatility, though. Concentrated positions expose you to company-specific risks, such as mismanagement, regulatory changes, or industry disruptions that can cause your stock (and consequently your wealth) to plummet. For a detailed set of factors that can drive company-specific risk, we also put together an in-depth look at concentration risk.

What diversification can mean for your portfolio

While the risks of holding a concentrated stock are pretty clear, the picture can get a little muddled when you start including capital gains taxes and FOMO in your analysis. Many investors decide that potential future appreciation and the impact of tax drag from realizing capital gains can outweigh the benefits of diversification. However, market data tells a different story most of the time. 

Historical analysis has routinely shown that broad market indices tend to outperform individual stocks over time. Past results are no indication of future performance, of course, but we conducted our own research with the high-growth Nasdaq Index, and saw similar results:

Individual Stocks vs. Nasdaq-100  |  2001 to 2023

Source: Cache, Bloomberg
This analysis is based on the returns of individual stocks in the Nasdaq-100 index from January 1, 2001, through September 25, 2023. Our analysis includes securities with different lifetimes in the index since securities are added and removed from the Nasdaq-100 over time. For the purposes of comparison, each security’s return is measured over its lifetime in the index.

In the 20th Century, the Nasdaq-100 has outperformed roughly 75% of individual stocks in the index, with nearly half of those stocks losing value in the long run.

The bottom line? Diversification from a concentrated position does not mean abandoning growth. In many cases, reducing risk specific to a single position can potentially lead to an even better outcome.

Diversification and taxes: a Catch-22 

Diversifying your concentrated position typically involves selling a portion of that position and redistributing the proceeds across a broader investment, such as a stock index. However, this approach comes with its own set of challenges—chief among them, the potential for significant capital gains taxes. For high-bracket investors with appreciated stocks, selling can trigger a major tax liability, eating into the very returns you’re trying to protect.

This effect can be massive. Take, for example, an engineer at a Magnificent 7 company like Apple. Over a period of eight to 10 years, it wouldn’t be uncommon to earn over $1,000,000 of Apple shares through the company’s RSU program. As the stock price moved from a range in high $20s a decade ago to over $200 in late 2024, those appreciated shares would accumulate tons of unrealized capital gains. 

If the Apple employee lived in a high-tax state like California and sold their position to diversify, those gains could be taxed at up to 37% (between state and federal taxes). Selling concentrated shares to “protect” their portfolio could wind up costing the employee hundreds of thousands of dollars.

But there may be better ways to protect your nest egg.  

5 alternatives to selling your concentrated stocks

Capital gains taxes can cut into returns, but there are several strategies to reduce them without staying married to the risk of a single stock. Here are a few approaches to manage risk without triggering a big upfront tax bill:

1. Exchange funds

Exchange funds offer a way to exchange your concentrated stock for a diversified basket of securities without triggering immediate capital gains taxes. Essentially, you pool your concentrated holdings with those of other investors, creating a more diverse fund by sharing stocks (and risk) with each other. Pooling your stock with those of other investors effectively diversifies your portfolio over time. 

Take the example of an Apple employee above. Rather than selling and paying up to 37% in capital gains tax (state and federal) in order to diversify, an exchange fund would let that person keep their entire principal in the market. Taxes would only be deferred (not avoided), but waiting to pay taxes can potentially lead to bigger gains over time.

Try this exchange fund calculator to explore different scenarios. 

To achieve the tax benefits of an exchange fund, investors must stay in the fund for seven years — so you should have a long-term outlook for any shares you contribute to an exchange fund. If this seems like something that might be a good fit, check our exchange fund overview, or take a look at a list of providers.

2. Collar advances (also known as prepaid variable forwards)

There are also tools like option collars and prepaid variable forward contracts (PVFs), which can let you borrow against the value of your shares while protecting you against a loss if your shares go down.

PVFs, for example, involve entering into a contract that allows you to sell your shares at a future date within a predetermined price range. An attractive feature of this strategy is that you can get cash today, while deferring capital gains taxes until the agreed transaction date. At the transaction date, you deliver whatever number of shares is equal to the dollar amount you received. This locks in the cash value of the asset and deferred taxes up front, but still leaves you on the hook for the same capital gains taxes down the road.

For example, a product like the Cache Collar Advance could lend the Apple Engineer up to 80 to 90% of the value of their shares at rates typically lower than a typical home mortgage. These loans typically last several years.  If the value of the stocks is lower than the value of the loan at the end of the period, the employee would be protected against a loss. If the stocks go up, the employee can pay off the loan and continue to watch their stocks grow. 

To keep borrowing costs down, there’s also an upside cap on performance. For example an 80/160 collar advance might protect up to 80% of the asset value while limiting potential gains to an additional 60%.

3. Direct indexing 

Direct indexing lets you build a customized portfolio that mirrors the performance of a stock index while holding the individual stocks directly. This allows for a personalized approach, where you (or more likely an asset manager) looks for tax-loss harvesting opportunities to offset the gains in your appreciated stock. This approach lets you reduce the impact of capital gains as you sell off your concentrated stock over time. 

While direct indexing can offer significant advantages, it generally requires a large investment minimum (in addition to contributing your appreciated shares).See how direct indexing compares with exchange funds.

4. Donor-advised funds (DAF)

For charitably inclined investors, donor-advised funds offer a dual benefit: You can donate your appreciated stock, receive an immediate tax deduction, and avoid paying capital gains taxes on the donated shares. The assets in the DAF — which are much larger than they would have been if you paid taxes on them upfront — can then be invested, and you can make grants to specific charities over time. 

While donor-advised funds help you maximize charitable giving (and deductions related to it), it does not maximize the investor’s personal return. 

5. Other strategies

Depending on the nature of your concentrated position and your long-term financial outlook you might also consider approaches like:

• Qualified small business stock (QSBS) exemptions: For those invested in small businesses that qualify under QSBS rules, there are opportunities to exclude a portion of your capital gains from taxes. This requires meeting specific criteria and holding the stock for a period of at least five years. It may be applicable, for example, for employees or investors in early-stage startups that eventually have an IPO.
• Estate Planning: Gifting shares to family members or placing them into trusts can help to manage concentrated positions, reduce estate taxes, and plan for wealth transfer, though this requires careful legal and financial planning. In some cases, the cost basis for appreciated assets steps up when an asset is passed on to the next generation. These sorts of strategies are complicated and have a variety of requirements to follow so it is best to work with a qualified estate planning attorney when implementing.

What’s the strategy for diversifying?

Deciding how to diversify your concentrated stock position isn’t a one-size-fits-all proposition. The right strategy depends on factors like how quickly you want to reduce risk, your need for liquidity, the level of capital required, management costs, and your overall tax situation. 

Caveats aside, here’s a quick comparison of some popular options for managing with concentrated stocks:

How to unravel your position

If you’re ready to reduce your concentration risk, the next step is to tailor a strategy that aligns with your financial goals, risk tolerance, and personal circumstances. Here are some actionable steps to guide you:

1. Assess your portfolio: Take a comprehensive look at your holdings, focusing on the size of your concentrated positions and how they align with your risk tolerance and time horizon. 
2. Consider your time horizon and liquidity needs: Some strategies, like exchange funds, require a long-term commitment, while others, such as direct indexing, offer more immediate flexibility (but less tax efficiency in the short term). Before you choose an approach be sure you have a strong understanding of your liquidity needs. Are you going to buy a house, pay for college, or retire soon? Your time horizon could limit how much of your portfolio you want to place in different vehicles.
3. Evaluate the tax implications: Once you know how much you’d like to diversify and how soon you’ll need access to any proceeds, understanding the potential tax consequences of diversification strategies is a crucial next step.  If you’re not clear about the implications of any moves you’re considering, consult with a tax advisor to explore ways to minimize your liabilities.
4. Choose your strategy: Managing a concentrated stock position is complex, and it may make sense to consult a professional. An advisor can help you evaluate your options, suggest a clear path forward, and connect you with the right opportunities. Look for advisors who are likely to work with numerous investors in situations like yours.

With the right strategy, you can protect your wealth without missing out on future growth. And if an exchange fund or collar advance seems like it might be the right solution, we’d be happy to explain eligibility and all the ins and outs. Just tell us about your situation to get started.

<div class="blog_disclosures-text">This communication is for informational purposes only and is not an offer or solicitation of securities. Any discussed product should be purchased only after reviewing the offering documents and signing a subscription agreement. This product may not be suitable for all investors, and Cache does not consider individual investment goals. Before investing, carefully evaluate the associated risks and ensure the investment aligns with your objectives and risk tolerance. Please note that investing involves risks, including the potential loss of principal. While Exchange Funds allow for tax deferral, they do not eliminate tax obligations upon asset sales. To benefit from tax deferral, you must follow the restrictions in the offering documents. Consult your tax advisor for personalized advice.</div>

<div class="blog_disclosures-text">Securities are distributed by Cache Securities LLC,/Member FINRA/SIPC.  Advisory services offered through  Cache Advisors LLC who is the advisor to the Cache Exchange Funda and is an Investment Advisor registered with the SEC. Registration with the SEC does not imply a certain level of skill or training. Cache Securities and Cache Advisors are affiliated and under the common control of Cache Financial, Inc.</div>

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