Welcome to the Blue Money Report

From the above table we can conclude that while the median (50 percent) outcomes are similar, owning a single stock results in a wider range of outcomes (what are known as fat tails). While investors in the diversified portfolio have a smaller chance of achieving an exceptionally high return, they have a higher probability of avoiding bad outcomes (failing to achieve their financial goals). For risk averse investors this is a good trade-off.

Summarizing, individual stocks are usually more volatile than broad market indices. Investors should not expect excess return above the market return as compensation for this diversifiable risk. They should, however, expect that individual stocks will be more volatile than a diversified equity portfolio. The prudent response to this diversifiable risk is to diversify as completely as possible and only take risk for which one expects reward (a risk premium). For investors who hold large individual stock positions, excessive volatility increases the risk of spending shortfalls in retirement. As the percentage allocation to a single stock increases, the risk of shortfall increases as well.

Despite the logic of the benefits of diversification, many individuals refuse to sell the stock in their company, or sell stock they inherited (the endowment effect). One of the reasons might be that the stock has a very low cost basis, and they don't want to pay a hefty tax bill. Given that the current long term capital gains tax is at its lowest rate ever, this does not seem to be a logical argument for holding. The maximum tax one could pay is just 15 percent at the federal level, and any stock can drop in price by 15 percent even in one day. For those that simply cannot pull the sell trigger, the following are offered as suggestions.

1. Develop a plan to gradually sell the stock, avoiding a black or white, sell or hold, decision. For example, the plan might be to sell 10 percent of the stock each quarter, or 25 percent each year, or any similar plan. The key is to write it down and sign the plan to help increase the odds that discipline will be imposed.
2. Create a stop loss program. Consider a stock that is selling at 50. In order to ensure that the investor doesn't ride a stock down to zero, a plan might be to place a stop loss order for say 25 percent of the stock at 45, another 25 percent at 40, another 25 percent at 35, and the final 25 percent at 30. The percentages and the amount of the stop (in this case limited to 5 dollars in each case) are not important, but the plan is important. Ask yourself how much downside risk am I willing to accept before the pain becomes too great.
3. Another version of the stop loss plan is to make it a moving stop loss. If the stock in the above example rose by say 5 from 50 to 55, then all the stops would be raised by 5. Each time the stock rose by 5, the stops would all be raised by an additional 5. This allows the investor to minimize the risk that they don't watch a stock go up and then right back down again. At least some of the gains can be captured. Note, however, that no version of stop losses can be guaranteed to work. A company can experience a particularly negative event that can cause the stock to drop well beyond the point of the stop loss.
4. A covered call writing program can be initiated. Calls give the buyer the right (but not obligation) to buy the stock in the future (for a limited period) at a specified price. For this a premium is paid to the seller of the call. Calls provide the seller with current income, and thus in effect some downside protection as well (while giving up some upside). Say it is January and a stock is selling at 50. A June 55 call might sell for 2. If the stock does not rise above 55 before the expiration of the call the seller simply pockets the 2 as income. If it goes above 55 the stock will be called and the seller will receive 55, plus the 2 call premium, for total of 57. The seller of course should root for the stock to go up. It will then be called and he/she can then diversify, feeling good about the incremental profits they were able to generate. On other hand if the stock falls, at least they earned the call premium, and can write another call once the original one has expired. Covered calls can also be combined with stop losses.
5. A collar can be established (if the stock is not restricted). A collar involves the simultaneous purchase of a put and the sale of a call. The investor buys a put giving them the right, but not obligation, to sell the stock if it drops below a certain level. The put thus provides insurance against downside risk (for which a premium is paid). The call works as described above. Generally these are down on a "zero-cost basis," with the prices of the put and call set so that the premium paid for the put offsets the premium earned on the call. In order for this not to be considered a constructive sale of the stock (triggering capital gains taxes) investors are typically advised to make sure that the put is at least 5 percent below the current market price and the call 10 percent above. If the collar is for more than one year then larger percentages must be used. Collars limit the downside risk, at the expense of limiting upside potential. Note that collars can be designed with wider spreads between the put and call prices (accepting more downside risk in return for keeping more upside potential). Before entering into a collar an investor should certainly consult a tax expert. A properly constructed collar can be a very effective tool to allow for the holding of a stock (while minimizing downside risk) until long-term capital gain treatment can be achieved.
6. For those trapped by taxes, and willing to make a major donation to charity, the stock can be put into a what is called a donor advised fund, and then sold immediately, with the proceeds used to build a diversified portfolio. The individual gets an immediate tax deduction for the full amount yet can donate the dollars over time.

Before concluding, we need to cover one more point. Investors with large capital gains in their concentrated position might also be holding other securities in taxable accounts whose value is less than the tax basis. If this is the case the losses can be harvested by selling those securities as well. The losses can then be used to offset gains realized. However, it is important to note that losses in taxable accounts should be harvested on a regular basis, whenever the tax benefit exceeds the transactions costs, if any.

Summary Having more than a relatively small amount (perhaps 10 percent) of your investable net worth in any one stock moves one from an investor to more of a speculator (taking substantial uncompensated risk). This is not a prudent decision when substantial dollars are involved. Thus concentrated positions should be avoided whenever possible. Portfolio risk can be substantially reduced by selling the concentrated position and using the proceeds to build a globally diversified portfolio that reflects your unique ability, willingness and need to take risk. Finally, if you are ever tempted to put lots of eggs in one basket, remember that while this is the surest way to make a quick fortune, it is also the surest way to lose one.