There’s no such thing as a ‘risk-free’ investment. Even seemingly risk-free investments such as FDIC insured CDs, Money Market Accounts and U.S. Treasury Notes carry risks including long-term devaluation due to inflation and loss of purchasing power.
Once you move into stocks, clearly no stock is devoid of risks. Stocks by their very nature have a fairly wide range of volatility.
5% Rule: No single stock holding should represent more than five percent of a client’s total portfolio.
I’m reminded of a case where a client held a highly concentrated position of a particular bank stock. Over the decades, this stock had performed well and created significant wealth for this client. At review time each year I would remind her of our 5% rule and recommend that we sell a minimum of ten percent of her holdings, noting that if the stock continued to rise she might simply be ‘treading water’ on the value but reducing risks over time by diversifying into other stock holdings. Because this was the stock that ‘brought her to the party’ and was a gift from her father, she continued to resist selling any shares. Then the Great Recession of 2008 hit…and hit bank stocks particularly hard. When this $25 per share stock had fallen to $1 per share I get the phone call, “Sell!”, she screamed into the phone!
Of all the stocks I have watched over the years, this bank stock appeared to be one of a handful that I thought just might be the golden ticket…until it wasn’t. What I learned was that there’s absolutely no such thing as a ‘sure thing’. There’s the potential ‘black swan event’ for virtually any investment. This is why the 5% Rule is so important.
Exceptions to the 5% Rule
- Management. If you’re a manager in your company, we ease the rule and allow the concentration to rise to 10%. As a manager hoping to move up in your organization, it’s important to show your willingness (to senior management) and confidence to take a large stake in your company. You’ll likely have stock options and other opportunities to purchase company stock, often at discounts to current value.
- Senior Management. As part of the senior management team, you may have no choice but to hold much of your wealth in company stock. At the point you’re no longer part of senior management, we recommend working your way back towards a maximum five percent stake in the company. A mistake we see a lot of retired senior executives make is to hold on to their shares out of loyalty, nostalgia or a confidence that it will continue to outperform. I’ve seen this fail enough times to know better.
- Taxes. One of the biggest roadblocks to selling highly concentrated positions is that often the stock has a very low cost basis. Taxes do matter…a lot. Under current tax law, a high-income earner potentially faces a federal 20% long-term capital gains tax; plus a 3.8% Obamacare tax on investment gains; plus a 5% state tax (Alabama) for a total of 28.8%. Losing nearly thirty-percent of your money to taxes is quite a bite. Some tax strategies include:
- For more elder clients we might ‘wait it out’…hold the stock until the client’s death at which time the children (inheritors) will receive a stepped-up cost basis and can sell and diversify with little or no taxes.
- Sell shares over a number of tax years. This spreads the tax bite out, lessening the pain in a given year and occasionally allowing you to pay taxes at a lower rate.
- Gift low-basis shares to charity. For charitably-inclined clients, we will use low-basis shares to give to qualified charitable organizations or a donor advised fund and use cash to diversify away from the concentrated position.
- Hold the over-concentrated shares. If, after performing a net worth/retirement analysis, we determine that a loss of the stock would not affect the client’s lifestyle, then the client may choose to take the added risk of maintaining the over-concentrated stock.
What to do now
Review your portfolio to identify any stock positions exceeding five percent and make a conscious decision regarding appropriate changes, if any.
Stewart H. Welch, III, CFP®, AEP, is the founder of THE WELCH GROUP, LLC, which specialize in providing fee-only investment management and financial advice to families throughout the United States. He is the author or co-author of six books including THINK Like a Self-Made Millionaire; 100 Tips for Creating a Champagne Retirement on a Shoestring Budget; and J.K. Lasser’s New Rules for Estate, Retirement and Tax Planning (John Wiley & Sons, Inc.). Visit his Web Site https://welchgroup.com/next-step/. Consult your financial advisor before acting on comments in this article.