In this episode, Michael MacKelvie, wealth advisor, breaks down the potential dangers of an overly concentrated investment portfolio and shares actionable strategies to help you achieve the right balance between growth and protection. He’ll share valuable insights into the risks of putting too much weight on a single investment or sector, how diversification can enhance long-term financial stability and practical tips to assess and adjust your portfolio.

Transcript

Michael MacKelvie: Investors can often feel a sense of paralysis when staring at a concentrated position, a position that has maybe grown over time and has taken up too much of their portfolio. But what can be done about this? What strategies exist? What benefits might exist to holding versus diversifying away? How can you do that tax efficiently? That’s what we’re here to talk about today.

My name is Michael MacKelvie. I’m a certified financial planner with Mariner. Your listening to Your Life Simplified. And as a planner, I have come across hundreds of these situations. They typically go like this: “I’ve worked at a company now for a number of years. I’ve built up a large portion of that company stock.” Or, “I bought a bunch of stock 10, 20 years ago. One of those stocks that’s just done really well, and I don’t know if I want to sell it, because if I sell it, then I’m going to have to pay a bunch of taxes.”

This assumes something critically, though, that you won’t have to pay taxes if you hold onto that position and sell it later. Of course, we know that’s not true unless you plan on donating it or dying, which the second one, I guess two out of two people, it’s going to happen to all of us. But if that is not your plan, then you’re almost certainly not going to find yourself in the 0% capital gains rate, which means you’re probably going to have to pay taxes on this at some point in time when you sell it. Okay?

So, the question becomes, then, what is the benefit of tax deferral? And this is something that very few people actually take time to figure out. So “I don’t want to sell this position because I’m going to have to pay all these taxes.” Well, what is the benefit of holding onto that position from a tax deferral standpoint? So we’ll put aside the fact that you maybe feel great. We’ll come to that in a second. You feel great about the company. What is just the tax benefit of holding that position? This is something that very few people calculate or just take time to figure out.

Let’s say you have a position that, just for round numbers, went from a hundred to 200,000, a $100,000 embedded gain. There’s a $100,000 long-term capital gain on that stock, okay? If you’re in the 15% capital gains rate, that’s $15,000 in taxes you would have to pay if you decided to, “Hey, I want to sell this, diversify away.”

So, the real question here, if we’re trying to determine what the benefit of the tax deferral is, what would that $15,000 have done for us? Okay? So, what we’re trying to figure out is what is the benefit of the tax deferral for that $15,000? Again, for just this example, I’ll save you the math. It’s about 0.65% per year, all else equal. Okay? Now, if the growth goes up in our hypothetical, so let’s just say we go to a growth rate of 12%, a higher growth rate, or we have maybe the velocity of this maybe slightly more. Then that benefit of tax deferral can be larger. Sorry, if you’re in a higher tax bracket as well, that benefit of tax deferral can be larger. But if we’re just assuming a typical return in a 15% rate, it’s about 0.65% a year, probably not something you’re getting too fired up about.

Now, that’s better than nothing. We’re certainly going to take that in comparison to nothing. But in the world of financial planning, and I would say this is probably true for life, too, it’s about trade-offs. There’s a trade-off to everything. You’re sacrificial either way, whether you like it or not. So what is the sacrifice that we’re maybe taking by holding onto this position and getting that additional half to 1%, let’s just say roughly, of benefit each year? What is the trade-off of that?

Well, the first piece you’re probably aware of, you’re like, “Hey, I understand there’s a risk to holding this much money in one stock. I’m a little worried if something happens with that stock, but I feel pretty good about it.” That’s usually what I hear the most. And the reason we feel good, it’s probably because the company has done quite well. That’s why you have a large gain in that stock. You probably don’t feel as good if it’s underwater. It’s not even really much of a conversation. “Hey, I got some losses I can use.” But the stock has done really good, so you feel good about it.

Curious about this. I just wanted to look historically, if we look back 20 years ago, how did the top 10 companies from 20 years ago do over the last 20 years? There’s kind of this mega-cap buzz right now … everybody feels great about the big boys. They feel really good about these big companies. So if we look back to the top 10 companies from 20 years ago, how did they do over the last 20 years? And I did not know what to expect in going into this, and we’ll actually, we’ll either leave it as a link for this or we’ll put this up on the screen in post as well.

Nine of the 10 failed to beat the S&P 500. So we got a lot of companies here that I’m just going to say some names. Citigroup, GE, Microsoft, Cisco, Exxon, Intel, Pfizer, Walmart, Johnson & Johnson, IBM, top 10 companies from 20 years ago. One, Microsoft. No, this is not a Microsoft commercial. I know I’m in Seattle. This is not a Microsoft commercial. Microsoft is the only company that did better than the S&P 500 over the last 20 years, up until the date at least that we ran this, which was springtime this year. But none of them would’ve caught up, from my experience, because guess what? Six of the 10 did worse than half of what the S&P 500 did. This is always a risk.

Now, just think, if you were to ask the employees of these companies 20 years ago, “How do you feel about the stock at your company?” Well, a lot of familiarity, they work there, they probably feel pretty good. They maybe saw incredible gains up to that point. So is it realistic that if we look at the top 10 companies today, something like that could happen? I don’t know. But at the very least, it’s a possibility that if you have a large position in a stock, it might not do what the S&P 500 or some stock index might do. Okay?

So that’s, of course, the risk, and I think that just provides a quick example of, hey, over the next 20 years, it might be the case that your company is a part of those nine of the 10. Might not be every 20 years that we see the nine of the 10 do worse than the index, but still, that’s a real risk, a very real risk.

So understanding this, it kind of gets into, “Well, what am I doing here?” And it gets into this idea of risk. What’s a compensated risk versus an uncompensated risk? Let’s just assume that whatever stock you hold has an expected return to it. That expected return is likely going to be roughly what the S&P 500 is. The difference is going to be the range in possible outcomes because you have one company which can bounce up and down a lot more versus just the basket of, let’s just say, 500 top companies, the S&P 500, let’s just say, right? So the difference is not so much the expected return, but the range of possible outcomes, i.e. volatility.

So are you being compensated for that additional volatility that you’re taking on? Not really. You’re not really being compensated for that. So this is what some might look at and say, “Well, that’s an uncompensated risk by holding just that one stock.” If you’re doing nothing else and you just hold that one stock, it’s kind of an uncompensated risk that you’re taking on.

So what can be done about this? Because this is all great, and in my conversations, we usually get this far. People totally understand this. And then it’s like, “Okay, well, but what are we doing here? I still have this potential tax I have to pay. I don’t know if I feel great about this.”

So what can be done? Well, there are strategies to where you can diversify away and potentially not have to realize those gains. There’s different ways you can do that. You’ve maybe heard of direct indexing, where you can capture losses actively throughout the year through tax-loss harvesting and offset some of those gains, and maybe you’re selling a portion away, as much as you can as far as the losses you can capture in that direct indexing strategy, you’re diversifying away a chunk of it each year. That’s one strategy.

And in my experience, this is just anecdotal, it’s not strict advice, it’s about 15% to 20%, if we get a good basket of stocks, about 15% to 20%, we can diversify away each year. That’s a nice exit strategy. You at least have some philosophy, something that you can buy away. “Hey, I’m going to be moving away a chunk of this each time.”

There’s other strategies where you’re maybe doing a long-short play and you’re able to amplify or accelerate that process, and you can maybe get away from that large concentrated position much quicker, much quicker, within one to two years. And again, there’s additional risks associated with this that I’m not going to cover fully right here because those are full conversations, likely with an advisor at some point. But just understand there are ways that you can exit that position, diversify away and maybe not have to pay as much of the taxes in year one.

If you’re just dead set on, “Hey, I don’t want to pay any taxes on this, I’m trying to defer this as long as I can, maybe to death or just as long as I can to where I drop from the 20% down to the 15% bracket,” whatever it might be, there are strategies to do that. That is why it’s important to meet with an advisor, because you kind of graduate away from just conventional, “Hey, I can sell a little. It’s around the holidays, I’m going to sell a little bit here end of year, capture some losses, offset some gains.” You maybe have graduated away from that into a new echelon of planning that’s just a little bit more complex. I would recommend maybe talking with an advisor if you’re at that point.

But what else can you do? I recommend setting a capital gains budget. In Washington, it’s very easy. They just have this new state capital gains rate up to 250. So 0% up to 250, anything above that, you pay seven. That’s kind of an easy line in the sand of, “Hey, maybe I just want to realize up to 250 at the very least because I got 0% state capital gains rates.” So that might be something that is just an easy line in the sand, but either way, setting some capital gains rate up to maybe a tax bracket, whatever it might be.

You can also establish a gifting system. If you want to gift a bunch, maybe you gift it all in one year to get the best tax benefits all in one year, but maybe setting up some gifting philosophy for yourself. And obviously, you can get a little bit more if you gift a large concentrated position that has grown a lot, you can gift a little bit more in that you get a little tax savings in the process by maybe gifting a position that has grown a bunch. So maybe you’re looking at that large position and you’re saying, “Okay, I’m maybe going to earmark that to gift away this year or next year, or a portion of it.”

But holding onto this position just will continue, even if it grows. Let’s assume that it grows, in its best-case scenario, it’s just going to continue to create challenges from a financial standpoint. You think about rebalancing, you think about as you get into retirement and you need to generate income streams because you got to replace the income that you’ve had through working your whole life. That is what retirement is, it’s just a replacement of income. So, it will continue to create challenges for you, and if it goes up, it will compound. That problem will compound. So, delaying dealing with this is not advised. I would recommend looking into the different strategies, speaking with an advisor, a tax plan or whatever it might be as well. This is going to continue to be a challenge.

So again, today, I just really wanted to highlight some history because we can learn from history. It’s not going to be a direct indicator of exactly what will happen over the next 20 years with your position, but it is a reference point of, okay, it might not do better than the benchmark. At the same time, there are definitely ways of dealing with this. Paralysis is a choice, so that might be delaying this decision and delaying and compounding this problem. I recommend dealing with it sooner rather than later.

If you’re listening to this on Apple, Spotify, wherever you might be listening, make sure to subscribe for more industry insights here at Mariner. Happy holidays as well, this is our last episode of the year. We won’t see you again, we’re going to take a little break here until January, but make sure again to subscribe if you’re enjoying this, if you feel like you’re getting a lot out of it. At the very end, though, happy holidays and hope you have a good new year.

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