Great fortunes are sometimes built on the narrow foundation of a single company's stock. (Think Microsoft (MSFT)). Great fortunes are also lost that way. (Remember Lucent Technologies (LU)?) With the brutal bear market still fresh in their minds, wealthy investors with a lot riding on one company's fate are looking for protection. "They're selling or hedging their exposure," says Don Weigandt, a wealth adviser at JPMorgan Private Bank (JPM) in Los Angeles.
Now is a good time to take action. Why? The top federal long-term capital-gains tax rate, which generally applies to sales of stock held for more than a year, is just 15%, down from 20% in early 2003 and 28% a decade ago. That means the tax bite is perhaps the lowest it will be in our lifetime. Here's another key statistic: The average large-cap stock is 44% more volatile than it was a decade ago, says Daniel Loewy, research director at Bernstein Wealth Management Research. So the risk of suffering a loss on a single stock position is greater today than in the last several decades.
Paring or selling an outsized holding is not a market-timing decision. Most advisers say it's best to reinvest the proceeds in a diversified portfolio. You may give up the potential for shoot-for-the-moon profits, but you'll get investing's equivalent of a free lunch -- enhanced returns with less risk, on average. How so? Since 1984, stocks in the Standard & Poor's 500-stock index with an average level of volatility have returned 10.3%. If that return reflects what's to come, two-thirds of the time, these stocks can be expected to swing between a 46.3% gain and a 25.7% loss. In contrast, two-thirds of the time, the S&P index can be expected to swing between a 31% gain and a 5% loss. Why the lesser spread? Not all the stocks in the S&P rise and fall together, so the gains on some at least partly offset the losses on others. The S&P's history of fewer and less dramatic losses has also helped it earn a higher average annual return than the average single stock in the index -- 13%, vs. 10.3% since 1984, according to Bernstein.
How much should you sell? Loewy recommends unloading as much as it takes to protect your goals, such as guaranteeing a living standard or assuring a bequest to heirs. To set a target, the firm runs an analysis that quantifies your chances of meeting your financial goals with various amounts of the concentrated stock based on a host of potential outcomes for the market and your stock. A financial adviser can run the numbers, too.
Your time horizon is another consideration. The longer you can afford to invest the proceeds from a stock sale in a diversified portfolio without touching it, the more of your stake it makes sense to sell. If the last 20 years is any guide, a diversified portfolio will earn more than the average stock, and that will help recoup the money lost to capital-gains taxes.
If an immediate sale isn't possible, some alternatives can achieve a similar result. One is a collar. This involves buying a "put" -- an option that lets you sell your shares for a specific price. If your stock trades at $100 a share, for example, you might buy a put for a fraction of the share price -- say $3 -- that protects you by guaranteeing a $90 sale price over time periods ranging from one month to three years.
To reduce the cost of the put, sell a "call" option, advises Michael Carr, head of equity capital markets at Citigroup Private Bank (C). With this strategy, another investor pays you for the right to buy your stock at a predetermined price -- say, $120. Of course, if your stock rises to $125, you'll be forced to sell at $120. But you'll still capture $20 of gain above today's $100 price. If your goal is to own a diversified portfolio, you can buy one by taking out a loan secured by your collared stock's value, says Weigandt.
If you've got stock worth $3 million or more, you can enter a contract called a prepaid variable forward (PVF). Here's how it might work for a $100 stock: An investment bank pays you some fraction of your stock's current value -- say, 85%. (The exact amount will depend on factors including the contract's length and the level of interest rates.) As a result, you'd be able to plow that $85 a share into a diversified portfolio. If the stock falls, the PVF protects you since you get to keep the $85. If it rises, you'll get the $85 plus a share of the gains. Typically, the higher your stock's volatility, the more upside you'll to get to keep, says Weigandt.
When the prepaid expires -- typically, in two to five years -- you can deliver your stock to the bank, triggering a sale and a tax bill. The number of shares you'll owe depends on the stock's price when the contract is up. Or you can delay the day of reckoning with Uncle Sam by delivering the cash equivalent and keeping your stock. You can also enter into a new prepaid -- but be cautious since you'll take another discount on your stock. And, as with cash settlement, there may be tax complications -- so consult a tax adviser.
Prepaids are often used to defer taxes. They can even help wipe them out. For example, if a stock owner dies before a contract expires, heirs can calculate the taxable gain using the stock's appreciation since the owner's death instead of the gain since purchase.
PVFs work best when a stock rises over the life of the contract. Why? If the stock you put into the PVF falls, you're guaranteed $85. But since you'll have to pay taxes on that amount, you'll wind up with less -- about $72 if you owe the 15% capital-gains rate on the entire amount. Had you sold the stock at $100, you'd be better off since you'd have $85 after taxes. But if the stock rises, the prepaid contract will give you $85 plus a share of the gains.
Another tax-friendly way to diversify is with a charitable remainder trust (CRT). This can be done with $100,000 and up. Since these trusts are irrevocable, they're only appropriate for those wishing to leave a charitable bequest.
Here's how it works: Say you put $1 million of stock into a CRT. The trustee can in turn sell the stock tax-free and invest the proceeds in a diversified portfolio. You're entitled to withdraw a set amount of money -- typically, at least 5% of the trust's value -- each year, paying capital gains or income tax depending on the source of the money. When you die, what's left goes to the charity you name. One of the benefits is that when you establish a trust, you get a tax deduction for the present value of the projected charitable gift. You'll get to deduct at least 10% of what you put in, says Weigandt.
Parting with a long-held stock that enhanced your or your family's wealth isn't easy. But to give your fortune a stronger foundation, it's important to take the extra risk out of a single-stock portfolio.
By Anne Tergesen