Concentrated Stock Risk for Target, Best Buy, and General Mills Employees

Minnesota has a lot of large employers with publicly traded stock and generous stock plans. Here’s how to manage the risk while being mindful of taxes.

Why diversify?

Sophisticated investors take several strategies to protect themselves against risk. One of these strategies is diversification. In short, diversifying means carrying investments across multiple securities and asset classes as opposed to having a high percentage of a portfolio concentrated in one specific area. Generally, by diversifying, the risk of a portfolio can be greatly reduced without negatively impacting the overall value of the portfolio.

Let’s assume an investor has all of his investments in the stock of one company. If something occurs with this company which causes it to go out of business, the investor would lose the entire investment and experience a 100% loss. Alternatively, let’s assume the same investor had a portfolio of 500 stocks, and one of those stocks went to zero while the remaining 499 stocks each experienced a 10% gain. In this scenario, the overall return for the investor was 9.8%. The 100% negative return experienced by the individual company had very little impact on the overall returns of the investor’s portfolio.

Diversification can be applied by carrying stocks of multiple companies, and additionally by allocating investments across various company sizes, industries, and locations. To further diversify, an investor can allocate a portfolio to multiple asset classes including stocks, bonds, cash, commodities, real estate, precious metals, and other investments. The power of diversification is realized from carrying investments that are negatively correlated to one another, in addition to investing in companies with varying levels of risk and various industries. As an example, historically there has been a negative correlation between the performance of oil companies and the performance of companies in the aerospace industry. Airline companies typically experience improved profitability and stock performance when the price of oil declines, while oil companies see reductions in profitability and stock performance during this time. Carrying investments in these two industries would provide negative correlation in an investor’s portfolio, increasing diversification and reducing overall portfolio risk.

Target, Best Buy, and General Mills

The returns of Target, Best Buy, and General Mills have been substantial over the last ten years. Target has experienced a 10-year annualized return of 16.94%, Best Buy’s 10-year annualized return is 17.38%, and General Motors had a 10-year annualized return of 10.91%. This means $10,000 invested with Target 10 years ago would be worth $47,822 today, $10,000 invested with Best Buy would be worth $49,652 today, and $10,000 invested with General Motors would be worth $28,165 today.

While an individual invested solely in any one of these three companies would have done well over the last 10 years, diversification should be considered to reduce risk as these returns could have easily gone the other way. Consider these other large cap stocks, Kraft Heinz is down 59% over the last 10 years, Centurylink down 62%, and Devon Energy down 66%. Risk is increased even more for an individual as an employee of a company. If the company goes bankrupt, not only does the employee lose his job, but he simultaneously loses a large portion of his investments.

It is important for an investor to understand company specific risks, also referred to as unsystematic risk. This is a risk inherent with a specific company or industry and can include competition from other companies offering similar products, regulatory changes which impact the ability of the company to be successful, management team issues, product quality, as well as many other risks involved in an organization. The companies themselves recognize these risks, as business risks are outlined within the respective annual reports for Target, Best Buy, and General Mills. Unsystematic risk is also known as diversifiable risk, as this risk can be greatly reduced for an investor through diversification.

Options to reduce stock concentration and tax considerations

If an individual finds that his portfolio is too heavily invested in one specific security, there are a number of options to disperse the portfolio among other investments while minimizing tax liability. Stock market gains have been substantial over the last several years, however this also can create a sizeable tax liability when those gains are realized.

From a Federal Income Tax standpoint, short-term capital gains are taxed according to the less preferable ordinary income tax rates. Generally, gains on assets held less than a year prior to selling are classified as short-term capital gains. Long-term capital gains tax comes into play when assets are held beyond one year prior to selling, and the tax rate is 0%, 15%, or 20% depending on taxable income and filing status. For a single filer, a 0% long-term rate applies if the individual has taxable income between $0 and $40,000 in the year the gain is recognized, 15% for income between $40,000 to $441,450, and 20% for income above $441,450. Income from the capital gain is included in this calculation as well as other taxable income the investor had in the given year from other sources. It is important for an investor to be aware of the existing tax brackets and implications of selling so that capital gains tax liability can be minimized.

Let’s assume an individual has taxable W2 wage income of $200,000 per year, and this investor has $1,000,000 of capital gains he would like to realize over the next several years. During the first four years, the investor can sell off portions of his portfolio which results in $241,450 in capital gains being realized in each of those years. When his $200,000 taxable income is added to this capital gain, his total income is $441,450 in that year which allows his entire capital gain to be taxed at 15%. In the fifth year, the investor can liquidate his remaining balance and remain in the 15% capital gains tax bracket. By applying a strategy to recognize portions of the capital gain in each year as opposed to the entire gain in one year, the investor avoids paying the 20% rate and saves roughly $50,000 in tax liability.

An alternative strategy would be to defer the capital gains to a year in which the investor anticipates his other wage income to be low, for example in retirement or during a period when an individual is between jobs.

An additional option for individuals who live in high tax states would be to use a trust when selling a stock position. This strategy can reduce the tax liability an individual incurs as a result of establishing the trust property in a lower tax state. An exchange fund, where an investor exchanges an individual stock for a collection of multiple stocks, is another strategy which allows an investor to exit a concentrated position while increasing diversification at the same time. There are several restrictions and requirements involved with Exchange Funds which should be reviewed in detail prior to proceeding.

A newer strategy to protect a concentrated position is a Stock Protection Plan. These plans involve a number of investors pooling together funds to cover 10% of their investment in a particular security, with most of these funds being invested in 5-year treasury notes. If the value of the individual stock declines, investors are compensated by this fund. One consideration with this option is the fees that are involved, as generally a 2% upfront fee as well as a 2% annual fee is required, so the costs of executing such a strategy may be worse than just paying the taxes

A final option to reduce tax liability in transitioning out of a concentrated stock position is to gift the stock either to Charity or to a family member. By gifting stock to a non-profit charity, a concentrated stock position is reduced while at the same time the investor receives a tax deduction for the donation. The charity can then sell the stock for cash and pays zero tax on the gains. This is a great strategy, particularly in the case where an individual was planning to donate cash to a charity and instead makes the donation with the stock shares.

Gifting shares of stock to adult children is another strategy that can be followed to minimize tax liability. Since adult children may be in a much lower tax bracket than the investor, net taxes owed for the family can be reduced. This could be especially advantageous for a young adult who may have little to no wage income, under which case it is possible that zero capital gains tax would be owed.

Summary

Diversification allows an investor to maximize returns and minimize risk by putting money into different investments which each have a different response to the same event. Although this is not a guarantee to protect against experiencing losses in a portfolio, diversification can help an investor manage risk and reduce volatility. When taking action to transition out of a concentrated stock position to increase diversification, it is essential to be mindful of the tax implications and plan accordingly.