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What to do about a concentrated portfolio

If you are concentrated in one security, diversify or take steps to manage the risk.

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Imagine this: You work for the same company for 20 or 30 years. It’s a good job, and in addition to your salary, you get paid through company stock. It can be a great deal—not only does it raise your overall compensation, but it gives you the opportunity to share in the company’s profits and growth. But with this attractive employee benefit comes the risk of inadvertent concentration of your investment portfolio in a single security.

The problem in investing, as in life, is that you can have too much of a good thing, be it from equity compensation, inheritance, or just a great run in an investment. As history reminds us, even long-admired blue chips can implode, sometime abruptly, taking overly concentrated investors down with them. So you may want to consider selling some of your stock and diversifying, or considering strategies to reduce the risk.

“History is littered with examples of high-quality companies that ended up in serious trouble—remember the bankruptcy of Lehman Brothers and WorldCom,” says Joe Steeves, senior vice president, Wealth Advisor Solutions. “The point is that a company that may look great today could get in trouble down the road, and you don’t know which one it will be, so investors need to think carefully about how they manage concentration in their portfolio.”

Bankruptcies, of course, are exceptions. But stocks losing value is a regular feature of markets. Research from Fidelity Strategic Advisers found that about 28% of stocks in the S&P 500® Index lagged the index by more than 15% each year between 1991 and 2010.

“The challenge of a concentrated position is that it can increase the risk level of a portfolio,” says John Sweeney, executive vice president of Retirement and Investing Strategies at Fidelity. “The simplest solution is diversification. But for investors who cannot or do not want to diversify, there are risk management, tax management, and income-generating strategies to consider as well.”

Spotting concentrations

How do you know when big becomes too big? Definitions vary, but here are the guidelines Fidelity uses in our Planning & Guidance Center.

  • Green (Does not appear concentrated)
    • <5% of assets for a single goal are invested in individual stocks or bonds from a single issuer (except Treasury or municipal general obligation [GO] bond issues).
  • Yellow (May be concentrated)
    • 5% to 10% of your assets in one individual stock or bonds from a single issuer
    • < 15% of your investments for a single goal in two stocks or bonds from individual issuers,
    • < 20% of investments for a single goal in three stocks or bonds from single issuers
  • Red (May be highly concentrated)
    • > 10% of assets for a single goal invested in one individual stock or bonds from a single issuer
    • >15% of assets for a single goal invested in two individual stocks or bonds from individual issuers.
    • > 20% of the assets for a single goal invested in three stocks or bonds from individual issuers
    • Four positions greater than 5% of your total assets for a single goal.

Strategies for handling a concentrated position

Fidelity believes in the power of portfolio diversification to manage risk. While diversification does not guarantee a profit, it can help to reduce risk, so we think investors generally should consider diversifying out of concentrated positions. But for some investors, that strategy is not appealing—either because of the tax implications of a sale or because, despite the risk, they remain devoted to the company or investment. We don’t think it makes sense to allow a desire to lower your current-year tax liability to drive a decision that might undermine the longer-term goals of a diversified investment portfolio, but if you are committed to keeping the position, you might decide to employ one of the following risk management strategies. These approaches may help manage taxes and sometimes even generate income from the position:

Staged selling. Sell a portion of your position each year over a set time period, say three or five years. This strategy may appeal to you if you would like to diversify but your concentrated position has very high embedded capital gains and the tax bill from an immediate sale would be too large to handle in the short term. A gradual sell-down would allow you to spread out taxable gains over several years.

Options. If your goal is to protect against downside risk without selling, consider purchasing put options. Option strategies are not right for all investors; they involve risk and expense. But puts can protect against the risk of losses in a stock, while maintaining your opportunity to participate in any appreciation. A protective put strategy can be an expensive way to hedge downside risk, however—so you want to be confident that any future gains will be enough to cover the cost.

Alternatively, you can use a covered call to generate immediate cash flow from the position. Covered calls limit your upside potential—if the stock rises you may be forced to sell you shares, but, they also provide income, and the income reduces your overall risk level. However, the income stream will not provide complete downside protection, so while this strategy provides a degree of risk reduction, it doesn’t protect against a large downturn.

If you want to hedge your position without incurring the cost of buying a put, you can use a cashless collar. This strategy involves purchasing a put to protect from losses while selling a call option that limits your upside potential. The proceeds from selling the call generally offset the price of the put—hence the strategy’s name. However, remember that puts and calls have embedded commissions and fees, so the cashless collar isn’t entirely free of cost.

Prepaid forwards. You may want the diversification benefits of selling your position and receiving some of the proceeds from a sale but not the immediate tax hit that a full sale would trigger. In that case, you could consider a strategy called a prepaid forward. This is effectively a binding agreement to sell the position at a specific future date, with a floor and a ceiling on the sale price. The sale and the tax hit don’t occur until that date, but you essentially lock in a price range, and get an advance on the proceeds, typically around 80%–85%. It is important to note that these strategies may require large minimum investments and are not available to everyone.

Securities lending. You may decide to loan a portion of your concentrated stock holding to other investors who want to borrow the stock as part of a short sale. The lender runs the risk that the borrower fails to return the securities or is delayed in doing so, but the lender will receive interest on the loan. This strategy involves giving up some liquidity, however, and it does not protect you from downside risk beyond the income. Again, it is important to note that these strategies may require large minimums and are not available to everyone.

Making a decision that works

Each individual needs to weigh the pluses and minuses of these risk-mitigation strategies versus an outright sale. But the important thing is to act. Keep in mind that a concentrated position can pose a serious risk to your financial goals. Even the most established companies can run into trouble, and when they do, you may wish you had diversified or hedged your risks.

Learn more

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Before investing in any mutual fund, you should consider its investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus, offering circular, or, if available, summary prospectus containing this information. Read it carefully.
Options trading entails significant risk and is not appropriate for all investors. Certain complex options strategies carry additional risk. Prior to trading options, you must receive from Fidelity Investments a copy of "Characteristics and Risks of Standardized Options" by clicking on the hyperlink text, and call 1-800-FIDELITY to be approved for options trading. Supporting documentation for any claims, if appropriate, will be furnished upon request.
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Diversification and asset allocation do not ensure a profit or guarantee against a loss.
Investing involves risk, including the risk of loss.
Guidance provided by Fidelity through the Planning & Guidance Center is educational in nature, is not individualized, and is not intended to serve as the primary basis for your investment or tax-planning decisions.
IMPORTANT: The projections or other information generated by Fidelity’s Planning & Guidance Center Retirement Analysis regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Results may vary with each use and over time.
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