Why Overconcentration is Risky—and How to Avoid It

Being overly concentrated in a stock is risky for your portfolio, but building wealth shouldn't be. Diversification and protection against significant losses should be core principles that guide your investment planning so that you can meet what's most important to you – your life and financial goals.

Instead of your portfolio and net worth depending on the performance of one stock, having a diversified portfolio allows you to better manage your investment risk by spreading your asset allocation among many stocks rather than being overly concentrated in one position. But diversification strategies and percentages can be complex—especially when it comes to equity compensation.

Ahead, we'll cover:

• The risks of overconcentration
• How to avoid overconcentration
• What to consider before selling company stock

Generally, holding more than 10-20% of your company stock can put your portfolio at risk of overconcentration. Overconcentration leaves you unprotected against big price swings in your employer's stock that could significantly impact your overall investment portfolio and net worth. If your company's stock is performing well, you might be tempted to think that it will continue to perform well; however, future performance is never a guarantee.

Your company's stock is subject to outside risks like market volatility that can cause the stock price to experience dramatic shifts. And you might not have the luxury of time or the ability to exit your stock position due to company stock-trading rules (more on that below).

Another risk of being overly concentrated is that your investment portfolio and livelihood could be in jeopardy if your salary or income is dependent on the company's performance. A high concentration of company stock can be quite beneficial and can lead to significant growth if things go well, but the ramifications for your investment portfolio and career could be significant if things go south. If you simultaneously lost your job and had a substantial hit to your portfolio, it could put your financial future in a tough position to recover, especially the closer you are to reaching retirement age.

You might have an overconcentration of company stock if:

• Part of your compensation package includes acquiring company stock
• You have large positions of your employer's stock in your 401(k)
• Your company stock appreciates faster than the broader market

Every investor's financial situation is unique and there are many factors such as your role in the company, the type of equity award you have, and your vesting schedule that can impact your decision of how much company stock to hold.

To mitigate some of the risks associated with overconcentration, work with a financial or tax advisor to develop a diversification strategy that aligns with your financial goals, risk tolerance, tax strategies, and retirement age (the closer you get to retirement, the more important diversification becomes).

You can also review your portfolio periodically and rebalance as needed. Not only will rebalancing help you watch out for overconcentration, it will also give you the opportunity to help make sure your asset allocation is in line with your goals. Over time, priorities can change—especially when a major life event occurs, such as a new job, new child, marriage, etc. Re-evaluate your goals and check on your investments at least annually to make sure they're still properly aligned with your goals and time horizon. If they're not, you can always adjust accordingly.

If you are considering selling company stock, it's important to take the tax implications and the company's stock-trading rules into account beforehand.

Based on the type of equity compensation you have, the timing of when to sell your award can significantly impact the tax amount you may owe. Consider, for example, capital gains tax.

Capital gains tax is a tax on profits from the sale of a stock. The amount you owe will be determined by how long you've held the stock and your yearly income:

• Short-term capital gains: If you've held the stock for one year or less, you will be subject to short-term capital gains tax rates. Short-term capital gains are taxed at the same rate as ordinary income tax, which ranges from 10 to 37% based on your income.
• Long-term capital gains: If you've held the stocks for over a year, you will be subject to long-term capital gains tax, which can be 0%, 15% or 20%, depending on your income. Long-term capital gains have more favorable tax treatment than short-term capital gains.

You may also be subject to a 3.8% tax if you are a high-income earner ($200,000 for single filers, $250,000 for joint filers). Contact a tax advisor to discuss your specific situation and determine when the most strategic time to sell your shares may be.

If you need to sell shares, make sure to know of any restrictions that may apply. If you frequently possess non-public confidential information about your company that could impact the stock price, you might be subject to blackout periods when you're not allowed to trade company stock, as doing so could result in legal consequences. Your company might also require you to pre-clear any trades and/or have a predetermined sales agreement (often called a "10b5-1 plan") with a broker to sell your stock.

Your company may also have stock ownership guidelines, based on your position, that need to be considered before selling stock to diversify your portfolio. If you're not sure, or for specific guidelines, contact your HR department to learn any stock trading rules that apply to you.