Byron S. Sass, BridgeTower Media Newswires
Wealth accumulation comes in many forms for individuals. One thing that many of these individuals tend to have in common though is that their wealth tends to be concentrated in one particular asset. This asset can be a wide range of things, a business that the individual started and grew from the ground up, stock options received as part of compensation for working at a corporation, stocks received as a part of inheritance, or even real estate. The question for these individuals is: How does one preserve and protect that wealth, make the transition to a diversified portfolio, and ensure it will be there in the future? For purposes of brevity, in this article I will focus on wealth that is tied up in a single publicly traded stock.
While a very large position in a single stock can lead an individual to great wealth, it can easily reverse itself and result in the individual starting back at zero or, even worse, in the red. This can be especially perilous in years leading up to retirement or in retirement as the time afforded to recover from a large drop in the stock price is not the same as it is for younger investors.
Certainty and security is essential when retirement is around the corner. While selling one’s entire single position and reinvesting in a diversified portfolio is the ideal course of action, sometimes there are obstacles preventing those actions.
An example of such an obstacle would be an individual who has 75 percent of their wealth tied up in a single stock they received in the form of equity compensation from work. What option does this individual have if they want to retire in two years and would prefer to lock in their wealth now but due to rules through work they cannot sell any of the stock until they have left the company?
One possible solution would be to enter into a forward agreement with a broker to sell all of their holdings in their employer’s stock at an agreed-upon price. The terms of the forward agreement would state that in two years the individual would sell their position of the stock at an agreed upon price regardless if the price had gone up or down. While the individual would be forgoing possible gains, they would be locking in their current wealth and protecting themselves from any steep declines in price.
Another potential obstacle could be an investor’s own personal biases for a stock’s future performance. For example, a high-ranking manager in a corporation may over attribute recent success in the corporation’s stock price and believe that they will be able to directly influence the price of the stock of the corporation going forward. This would be a textbook example of the illusion of control bias. Another example would be an individual who has inherited a stock that has been in the family for generations. In this case, the individual tends to overvalue the inherited stock versus if they were to go out and purchase it on their own at that moment. This is what is referred to as endowment bias. Both forms of bias discussed here present a unique challenge for financial advisers because perceptions and biases can be strong and emotionally based.
One way an investor could add some protection to their portfolio for either case above would be to purchase a put option on the single security in their portfolio that represents the majority of their wealth. A put option is a contract that gives the buyer the option to sell the security at an agreed-upon price in the future, but if the price were to increase they could choose to not exercise the option to sell and keep the shares in the stock.
For example, consider an individual that has inherited a stock which now represents 90 percent of her wealth. She disagrees with her financial adviser’s advice to sell and diversify but is persuaded to purchase a put option to limit her downside risk. For the purpose of this example assume that the put option gives her the right to sell the stock at $130 in one year and it is currently is trading at $150. If the stock were to have a bad year and move to $100 at the end of the year, she could decide to exercise the option and sell at $130 and only incur a loss of $20 per share instead of $50 a share. In the event the stock ends the year up at $200 per share, the individual would only be out the cost of the option and be able to enjoy the $50 increase in share price.
Preparing for retirement and ensuring all of your hard work is protected is a top priority for all. Even if you have concentrated positions that might not be easy to diversify out of, there are options available to minimize exposure to unnecessary risks that could derail your financial goals. To be sure, a diversified portfolio is the best way to mitigate those risks and protect one’s wealth. While the transition for moving one’s wealth from a highly concentrated position into a diversified position can be fraught with obstacles such as taxes, illiquidity and restrictions, working with a trusted financial adviser can help maximize an individual’s wealth and ensure they can enjoy retirement.
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Byron S. Sass, CFA is a Fixed Income Analyst/Account Manager for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, non-profits and trustees. Offices are located at 183 Sully’s Trail, Pittsford, NY 14534 (585-586-4680).
