How to Diversify Away from a Concentrated Stock Position
Holding a lot of your wealth in a single stock is often the result of financial success. Whether it comes from equity compensation (like RSUs or options), a startup IPO, or an early investment in a growing company, a single equity holding can produce significant wealth.
However, that concentrated position can turn into a liability if it becomes large enough. In financial planning, a concentrated position usually means a single stock makes up 10% or more of your total liquid investment portfolio. Such high exposure to a single stock exposes your overall finances to significant risks:
Company-Specific Risk is the chance that your stock will lose value due to factors unique to that particular company - such as poor management, shifting customer preferences, new technologies, or regulatory changes - rather than broader market conditions. These factors are idiosyncratic to that specific company, and can cause its stock price to drop quickly.
Volatility Risk is the heightened danger of severe price swings in a single stock that trigger deep drawdowns, making recovery much more difficult, as large losses require disproportionately massive gains to break even (e.g., a 50% loss requires a 100% gain to return to baseline).
Underperformance Risk is the high statistical probability that an individual stock will lag behind the broader market over time, due to the fact that market gains are primarily driven by a tiny fraction of outperformers (and it is statistically unlikely that your concentrated position happens to be one of these rare outperformers).
Dual-Exposure Risk emerges when your concentrated stock is in the company you work for, meaning that your monthly salary and your life savings are tied to the same enterprise. This creates a heightened vulnerability where a downturn in the company's fortunes can simultaneously trigger a layoff and wipe out your investments when you need them most.
The antidote to these concentration risks is diversification: swapping your concentrated position for a broader mix of equity holdings. This is typically done through broad market index funds, which spread your money across hundreds of companies so the failure of any one business won't significantly affect your portfolio.
However, because concentrated positions are often highly appreciated, simply selling them to buy index funds can generate massive capital gains taxes, significantly hampering the compounding growth of your portfolio. Realizing large capital gains in a single year can bump you into the 15% or 20% capital gains tax brackets, expose you to the 3.8% Net Investment Income Tax (NIIT), increase your state taxes, and cause you to miss out on various income-dependent tax credits and deductions.
This article outlines a set of steps you can take to unwind a concentrated position, to incur the least amount of tax exposure as you carefully reduce your concentration risk. It also outlines a few situations where you might choose to hold onto a concentrated position.
Step 0: Sell any new equity compensation immediately once received
If your concentrated position comes from ongoing equity compensation like RSUs or ESPPs, stop adding fuel to the fire by adopting an immediate sell-on-receipt rule. Selling new shares as soon as they land in your account halts any further buildup of your concentrated position. Some companies even offer an auto-sale option so you don’t have to remember to manually sell each new batch of shares.
Step 1: Turn off automatic reinvestment in your brokerage account
Most brokerage accounts are set to automatically reinvest any cash distributions (dividends, interest, capital gains, etc) which results in the continuous purchase of more shares of your existing holdings, compounding your concentration risk. Disabling automatic reinvestment (either at the account level or for a particular holding) directs all future distributions to remain in cash instead, which can then be used to diversify into broad market index funds.
Step 2: Liquidate shares held in tax-advantaged accounts
If any of your concentrated position is held in a tax-advantaged account - like a Traditional IRA, Roth IRA, 401(k), or HSA - you can generally sell it immediately without any tax consequences.¹ Capital gains taxes generally apply only to taxable brokerage accounts, so selling positions in tax-advantaged accounts and rebalancing the proceeds into broad market index funds won’t generate any taxes. (It is only withdrawals from tax-advantaged accounts that can generate tax liabilities.)
Step 3: Sell any flat or depreciated tax lots
If the concentrated position was acquired over time (such as through automatic reinvestment or equity vesting), it will be composed of different lots that each have their own basis and appreciation. Some of these lots might not have had time to appreciate significantly since they were acquired (or may even be trading at a loss), which means they can be liquidated without generating significant taxes. By selling those flat or depreciated lots, you can reduce your concentrated position with little to no tax impact.
Step 4: Consider donating appreciated shares to charity
If you regularly give to charity, you may be able to donate your appreciated shares instead of cash. Doing so eliminates the capital gains tax you would have otherwise owed on the growth, allowing you to give the same amount at a much lower cost, while simultaneously reducing your concentration risk. If your preferred charity is unable to receive donated securities, you can use a Donor-Advised Fund (DAF) to receive shares of your concentrated position, liquidate those shares without any tax consequences, and then donate the resulting cash to your favorite charities.
Step 5: Offset capital gains with tax-loss harvesting
If you have other investments in your taxable brokerage account that have gone down in value, you can sell them at a loss to directly offset the taxable gains from selling your concentrated stock. Regularly harvesting capital losses across your portfolio can enable you to steadily chip away at a concentrated position over time, balancing gains with losses to avoid any capital gains taxes. The cash generated from selling the depreciated assets can be reinvested in similar securities to maintain your desired market exposure.
Step 6: Consider funding withdrawals or rebalancing from the concentrated shares
When you need to raise cash for withdrawals or rebalancing, consider selling shares of your concentrated position rather than other assets. Obviously, if the alternative asset you were planning to sell has a similar or higher appreciation than your concentrated position, selling the concentrated stock instead is a no-brainer. But even if the concentrated stock has slightly higher gains, taking a modest tax hit is often worth it because it achieves two goals at once: generating the cash you need while also de-risking your portfolio.
Step 7: Spread sales across years to stay in lower tax brackets
Instead of selling your entire concentrated position in a single year, you can liquidate it carefully over multiple tax years to minimize the tax exposure. Keeping your annual sales below certain limits can prevent your capital gains from jumping into higher tax brackets (such as moving from 15% to 20%) or triggering the 3.8% Net Investment Income Tax (NIIT). This is especially useful if you anticipate your income increasing significantly in future years, making it even more challenging to diversify away from your concentrated position in a tax efficient manner.
Step 8: Consider gifting shares to family members in lower tax brackets
If you provide financial support to children or family members who are in lower tax brackets (such as for college expenses or a down payment on a first home), you can transfer appreciated shares to them instead of cash. They can then liquidate those shares at their more favorable tax rates (possibly 0%), significantly reducing your tax exposure and effectively decreasing the cost of your support, while simultaneously reducing your concentration risk. You can even do this for minor children by transferring shares into their UGMA account. There are limits to the amount of money that can be gifted to others, but it can be a powerful way to reduce concentrated holdings.
Step 9: Dilute the position over time with new contributions
If you anticipate having excess income to invest in the future, you can reduce your concentrated position over time, without selling any shares or incurring any taxes, simply by allowing it to be diluted by future contributions. Over time, as your total portfolio grows through contributions, the relative weighting of your concentrated holding will naturally shrink. While this approach takes time and will not protect against a sudden decline in the stock, it may be able to reduce your concentration risk to acceptable levels, especially for larger contributions or smaller concentrated holdings.
Step 10: Sell the shares directly and pay the capital gains taxes
Even after undertaking the tax-minimization steps above, you may still be left with a sizable concentrated position. As unpalatable as it may be, it might make sense to simply liquidate the position down to an acceptable level, and pay the capital gains tax on the proceeds. This is especially true for particularly large concentrated positions, or when the stock is more likely to suffer a significant drop in valuation. If the concentrated position has the ability to threaten your financial security or retirement timeline, reducing concentration risk is more important than avoiding taxes.
When does it make sense to hold on to a concentrated position?
While unwinding a concentrated position is generally the safest path, there are scenarios where keeping a concentrated stock (or some portion of it) might make more sense:
The concentration is high but manageable: If you feel that a massive drawdown of your concentrated position would not be catastrophic to your overall investment portfolio or financial stability, you may be willing to accept the concentration risk to avoid the tax hit.
You are confident in the potential for growth: You may simply remain bullish on the company's long-term prospects, and want to maintain your exposure in spite of the concentration risk.
You plan to have your children inherit the shares: If you want to pass the assets on to your heirs, holding highly appreciated stock until death generally results in a step-up in basis, wiping out decades of capital gains tax liability for your beneficiaries.
You would like to invest with leverage: If you are actively looking to add leverage to your portfolio, borrowing against your portfolio (via a Securities-Backed Line of Credit, margin loan, or box loan) can enable you to extract investable cash for diversification without selling shares or triggering taxes. However, it is important to understand that this does not actually reduce your concentration risk, and in fact amplifies your total portfolio risk: If the stock drops significantly, the lender can issue a margin call, forcing you to deposit extra funds or sell shares at market lows.
If you decide to hold onto a large position without borrowing, you can still manage the downside risk using specific portfolio techniques:
Build a Completion Portfolio: Instead of holding standard market-cap index funds alongside your concentrated stock, invest the rest of your portfolio in funds that deliberately exclude or underweight your stock's sector or industry. This prevents your remaining portfolio from compounding the same risks.
Limit Downside with Options: You can purchase protective put options to establish a price floor below which your stock cannot fall, or set up a zero-cost collar (selling a covered call to pay for the protective put). This caps your downside while avoiding a taxable sale of the underlying shares.
Appendix: Complex Strategies for High-Net-Worth Portfolios
For high-net-worth investors holding millions of dollars in highly appreciated equity, several specialized strategies exist for exiting concentrated positions in a tax efficient manner:
QSBS Exclusions & Section 1045 Rollovers
Qualified Opportunity Zone Funds (QOFs)
Grantor Retained Annuity Trusts (GRATs)
Charitable Remainder Trusts (CRUTs & CRATs)
Charitable Lead Trusts (CLTs)
Private Placement Life Insurance (PPLI)
Exchange Funds (Section 721 Swap Funds)
Equity Collars & Variable Prepaid Transactions (VPTs / VPFs)
Section 351 ETF Exchanges
Long-short strategies
While these structures offer powerful tax minimization benefits, they are generally impractical for everyday retail investors. They typically require multi-million-dollar minimum contributions, accredited investor or qualified purchaser status, multi-year lockup periods, complex legal setups, and ongoing management and legal fees that can easily exceed any potential tax savings for standard portfolios.
While selling stocks in tax-advantaged accounts does not generally have tax consequences, there are a few exceptions (such as Net Unrealized Appreciation for company stock held in an employer-sponsored retirement plan), so check with your tax adviser.
