We (like most) define a concentrated position as one where more than 10% of your invested assets are tied up in one thing. Think more along the lines of having 20% of your portfolio invested in Apple Inc. (AAPL) or a significant amount of wealth tied up in the value of a closely held business - not the fact that the value of your house accounts for a large percentage of your total assets.
In an investment account, this would look like having at least $100,000 out of a $1 million dollar account invested in a single company’s stock. People often find themselves in this situation if their compensation includes stock option plans through work – as you exercise your options you end up owning more and more company stock within a taxable investment account.
If you hang on to this company stock your entire working career, you can easily end up in a highly concentrated position. And if it’s the wrong company to be invested in, your overall game-plan could take a huge hit.
However, there’s one big factor that often keeps people from diversifying: taxes. Let’s say you initially paid $45.00/share for that company stock 25 years ago. Today, said stock is trading at $225.00/share. You own 450 shares total, for a value of just over $100,000, but your basis is only approximately $20,000.
If you sell that stock and diversify, you’re looking at a worst-case scenario of an extra $80,000 of re-portable income come tax-time, which could mean a $12,000 tax bill (even at long-term capital gain’s rates).
So what’s the opportunity cost here?
Vanguard published a study on concentrated positions trying to answer exactly that question. They found results to be in favor of diversifying out of concentrated positions despite the potential tax bill, but not without making tax-informed decisions and evaluating each unique set of circumstances.
Consider the overall cost of getting out of that concentrated position. If you have to pay a $12,000 tax bill out of a $1 million account, that’s only 1.2% of the total value, even if it is 12% of the concentrated position.
On the other hand, it’s harder to quantify the benefits of diversifying out of said concentrated position since there can be so many unknowns. This is where hindsight provides the most clarity; by having a concentrated position in one stock, you're taking on a huge risk that a large portion of your portfolio could become worthless over night. If you’re going to keep a higher degree of risk in your portfolio, you also need a higher return to compensate for that risk. If you're close to retirement and thus more risk averse to preserve capital, then that concentrated position should be keeping you up at night.
As mentioned, diversification of a highly-concentrated position can be managed tax efficiently. Don’t take unnecessary risks, and evaluate your options in light of the total long-term picture, not just the short-term tax bill.