The Importance of Diversification: How Much Is Too Much Company Stock?

Owning too much of one equity—any equity—can add risk to an investment portfolio. But this situation is of particular concern for employees who receive company stock as part of their compensation packages or in their retirement plans. These investors can benefit from knowing they are sharing in the success of the company they are helping to grow, but they face the potential risk of accumulating a concentrated position in their portfolio. This risk is compounded by the fact that their livelihood is attached to the financial health of the same company that represents a large portion of their portfolio’s value.

“Many executives and other employees generate a lot of wealth through company stock, so this is a common situation for investors to find themselves in,” says Roger Young, CFP^®, a thought leadership director with T. Rowe Price.

While there is no set definition for a concentrated position, in general, a position is concentrated if it represents more than 5% to 10% of your portfolio’s value. T. Rowe Price considers anything over 5% to be worth addressing, particularly when it involves company stock. Once a holding exceeds 10%, however, it represents a greater risk that merits more immediate planning. “The risk of a concentrated position can be magnified by additional career risk in the case of company stock,” says Marty Allenbaugh, CFP^®, CPWA^®, a senior advisor with the T. Rowe Price Private Client Group. “Someone whose compensation includes company stock can lose both investment value and income if the company encounters difficulties.”

Employer stock is perhaps the most common way that concentrated positions develop. For instance, employer contributions that are automatically invested in company shares in retirement plans can accumulate to high levels unless you are diligent about managing them. Employees may also receive company stock in the form of options or restricted shares as part of their compensation packages, which can further complicate the process of identifying the level of concentration risk.

A concentrated position can also occur when a stock appreciates faster than the broader market, which may be more likely to happen in certain industries. The most important step in mitigating the risk of concentrated company stock is to monitor your holdings on a regular basis. An annual review can help you identify concentrated holdings before they reach a level of risk that is higher than you are willing to accept.

The simple fix for a concentrated position is to trim the position to below a target threshold such as 10%. But resolving a concentrated holding of employer stock may not always be that easy. In addition to tax considerations and the psychological challenge of selling any winning stock, there are real and perceived limitations specific to selling employer stock. For instance, managing company stock can be affected by the following:

Blackout periods. There are periods of time when employees are not allowed to buy or sell company stock, often in the lead-up to an earnings announcement. In addition, there are typically company-specific processes for reporting and approvals that need to be followed. However, concentrated holdings usually develop over time, so managing the process and blackout periods should be possible with appropriate planning.

Confidence in your employer. Believing in your employer may make it hard to fully appreciate how much the company’s share price could decline. Remember that a company and its stock are not the same. You can support your employer without maintaining the same exposure to its stock.

Perceptions. You may be concerned that your bosses will view selling shares as a lack of commitment to the company. Some high-level executives must report their holdings and transaction of company stock to the Securities and Exchange Commission (SEC), leaving them open to public scrutiny as well.

Minimum holding requirements. High-level executives within an organization are often required to hold a minimum amount of company stock, such as the equivalent of one year’s worth of salary, while a CEO might be required to hold five times their salary. Those company requirements also typically prevent executives from hedging their positions with derivative securities such as put options. If you are subject to these limitations, they must be factored into your decision about whether to trim your concentrated holding and whether there are alternate ways to offset the added risks, such as reducing your exposure to your company’s stock or other stocks in the same industry in the rest of your portfolio.

If you’ve identified that your investment in company stock represents a concentrated position, there are a few ways to help mitigate the risks. Consider the following strategies as you decide what to do next:

Be thoughtful with holdings in a retirement plan. You can sell stock in a 401(k) or other retirement account without near-term tax consequences. Therefore, most people should periodically diversify into other investments.

If the company stock in your retirement plan is highly appreciated, however, you may want to hold it until leaving the company and then consider a strategy known as net unrealized appreciation (NUA). The strategy involves transferring appreciated company stock into a taxable brokerage account, while rolling over other holdings to individual retirement accounts (IRAs). While you would pay ordinary income tax on the cost basis at the time of the transfer, you can qualify for favorable long-term capital gains tax rates on the appreciation when you sell the shares. That gives you an opportunity to address any concentration issue in a more tax-efficient way. A host of tax and plan-specific rules apply, so be sure to consult with a tax professional or financial planner.

Sell restricted stock upon vesting. With restricted stock, an employee does not receive shares immediately—vesting requirements such as passage of time or fulfillment of performance goals must be met. Typically, the value of the stock is taxed as ordinary income once the shares vest. Therefore, there could be little or no additional tax liability if you sell restricted shares shortly after they vest. This strategy reduces an employee’s overall exposure (including unvested holdings) and helps prevent the risk from getting bigger if new grants are received.

Consider your stock options. Stock options allow employees to purchase stock at a “strike price,” typically the market price at the time they are granted. Therefore, the value of employee stock options depends on future appreciation, and is thus difficult to estimate, especially if the options don’t expire for many years. Despite that uncertainty, it is important to monitor the intrinsic value (market price minus strike price), as well as future potential gains. “Don’t ignore them,” says Young. “And make sure you consider how future transactions such as grants and exercises might affect your concentrated holding.”

When it comes time to take advantage of valuable options, consider a “cashless exercise,” if that method is offered to you. That alternative facilitates a transaction where the shares are purchased and immediately sold without the employee having to come up with cash upfront. Both the purchase price and the taxes are automatically paid from the sale proceeds, helping avoid a large tax bill at the end of the year.

Use a rules-based approach to managing holdings. Employees with large holdings of company stock can employ a systematic process to determine when and how to sell their holdings. That system could be based on share price and the value of their position relative to their overall portfolio. This strategy can help remove emotions from the decision-making process.

Certain executives can establish a formal plan, known as a 10b5-1 plan. This approach would be most appropriate for leaders subject to public reporting requirements who often learn material nonpublic information about the company. By giving up direct control over transactions, executives can avoid running afoul of the SEC’s insider trading regulations. There are many decisions to make when designing these plans, so coordination with the company’s legal counsel is critical.

Ultimately, the approach to managing a concentrated position of company stock is the same as managing other risks in your portfolio. The key is being aware of the risk and taking the steps necessary to manage it at a level that is appropriate for your situation. “Don’t think of this as a matter of loyalty or confidence in your company,” says Allenbaugh. “It is about managing your portfolio risks to achieve your long-term financial goals.”