Offset Volatility with Some Clever Variety

Physician's Money Digest, June15 2004, Volume 11, Issue 11

If you have a significant portion of your investmentportfolio in one stock, financial plannersrefer to this as a "highly concentrated position,"which is very risky. Physician-investorsoften have highly concentrated positions becausethey like to invest in pharmaceuticals or durablemedical equipment manufacturers that they know. Itmakes sense to invest in stocks you understand, butwhen one or a few assets hold the keys to your financialfuture, that translates into great risk. If you haveto liquidate when the stock goes down, you could bein for a rude awakening.

Emotionally Disengage

Even if you have a high concentration of historicallywell-performing stocks, it can be dangerous.Consider Bristol-Myers Squibb. Back in 2000, thestock was selling as high as $74 per share; today it'sselling at $24 per share—a loss of 67%. Another namebrand stock especially popular with doctors, Schering-Plough, was selling as high as $60 per share inDecember 2000. Today's market price is $16 per share.If either of these stocks were a substantial holding inyour portfolio, you would realize a significant loss.

For many doctors, stocks are not simply investmentvehicles; there's an emotional attachment to theirholdings, especially if they've worked with the company'sproducts for an extended period of time and knowhow effective they are. In other cases, the stock mayhave been left to the doctor by a spouse or an agingrelative. They feel as if the stock is the last remnant ofthat person, and selling it would be a betrayal. It's hardfor physician-investors to take an objective look attheir portfolio when these emotions are involved.

The key:

To overcome these issues, physicians need to takean overall look at where they are today compared towhere they want to be in the future. Recognize what you're trying to accomplish for youand your family. Do you need to protect your assets orminimize taxes? How liquid should your assets be? Areyou close to retirement? Will your portfolio be used tofund your retirement or your children's college education?The answers to these questions will help youdetermine how much risk you can tolerate in a portfolioand how diversified your portfolio needs to be.

Consider Strategies

There are a number of strategies for achievingdiversification in this situation. The following areamong the most popular:

• Selling the stock and paying taxes. This optioninvolves two issues: People are attached to the stockand averse to paying the taxes. You need to perform afull personal finance analysis, including a look at all ofyour assets. Next, look at how much this single stockrepresents of your total net worth. Analyze the potentialtax exposure, determine the total risk in youroverall portfolio, and balance it against your probablereturns of selling the stock and reinvesting the after-taxproceeds.

Once you've worked on this, develop a specificstrategy of how much of the stock to own, how muchto sell, and when. You may want to sell the stock overa period of time rather than all at once. Your focusshould always be a balanced portfolio aimed atachieving your goals.

• Using put options. Buying a put option could becompared to buying an insurance policy. An investorpays an upfront premium to buy the right to sell theirstock at a specified price within an established timeframe. If the stock goes up, the investor receives thefull benefit of the appreciation. If the stock declines,the investor has downside protection.

Buying the put option protects the investor if thestock price goes below a certain price. The investoralso retains dividends and voting rights. The cost—orrather, the investment—of the put and the complicatedtax issues involved can be discouraging factors.

Thebottom line:

• Using collars. To mitigate the cost of a put,investors may consider using a collar (ie, a combinationof purchasing a put option and selling a call option).Investors who use call options sell the right to buy thestock at a specified price within a certain time frame toanother person. There are no upfront payments with acollar because it only kicks in if something happens. The collar caps both the upward appreciationand downward loss. The good news is that it providesdownside protection below the strike price. It alsoallows the investor to defer capital gains and continueowning the stock. The bad news is that it eliminatesappreciation above a certain call price.

• Pooling the stock through an exchange fund.This offers a means of diversification without havingto realize a current taxable event. Investors involvedin exchange funds pool their low cost-basis stockswith other investors' stocks. Each contributorbecomes a stakeholder in the fund. After a set periodof time, each investor can redeem their share in thefund. They receive a nontaxable distribution of theentire fund's stock. This is one vehicle that allowsinvestors to diversify while simultaneously takingadvantage of tax deferral and estate planning benefits.

Caution:

The IRS has challenged these funds inrecent years. Another rub is that these pooled fundsare illiquid. Early withdrawal often results in thereturn of your original stock at your original basis,minus potential fund penalties. Most of these fundsoperate for a minimum of 7 years, so you can't withdrawbefore then. In addition, stakeholders have nocontrol over the stock and there are substantial managementfees involved. Before pooling, investorsshould work with skilled financial planners who arewell versed in the tax laws.

• Leveraging a charitable remainder trust (CRT).Establishing a CRT is appropriate for investors whohave stocks that have increased significantly sinceacquisition and have a low basis in their stock. Thesestocks can be a problem for investors because theywill generate a large capital gain when sold. For philanthropicinvestors, a CRT allows them to do somegood while mitigating a potentially large tax bill. Evenfor those who aren't as charitable, this is worth lookinginto; the CRT can provide an income stream thatmay not have existed before.

How does it work? An individual transfers theirappreciated stock to a CRT. The CRT then sells theappreciated stock and reinvests the proceeds. There isno tax to the CRT since it is a charitable organization.During the term of the CRT, the donor receives a taxablepayout during their lifetime or for a term ofyears. The donation or transfer of the stock to theCRT creates a charitable donation for a value dependingon how it is set up. This allows the investor toavoid the immediate payment of capital gains on thestock transaction and receive a current income taxdeduction based on the projected gift to a charity atthe end of their life expectancy or a term of years.

The downside:

This strategy is irrevocable and thereare tax consequences. There are limitations on theamount that may possibly be deducted as a charitablecontribution. This is another case where you have towork with a financial planner. The planner can help youanalyze the pros and cons of an outright sale as opposedto establishing a CRT to see if this works for you.

What it all boils down to is that the concentrationof wealth in one particular stock is risky. There are anumber of tactics and options that allow physician-investorsto diversify, depending on their personal situations,goals, and risk tolerance. Concentrated positionscome in all different shapes and sizes, as do thepeople who have them.

The potential approaches are numerous, and taxand estate laws keep changing. Seek professionaladvice to help you choose from among your options.The key to finding the right approach is working withan experienced financial planner who has a handle onthe current techniques. They can help you weigh youroptions and pick a comfortable solution. There's a lotyou can do to minimize the risk of loss if you plan.

Jonathan Gassman is the director of financialplanning at Gassman & Golodny LLP. The firmprovides independent and objective tax and financialplanning advisory services to individuals andbusinesses. The 80-year-old, NYC-based firmbegan as an accounting practice and added financialplanning in the late 1990s. The firm's financialplanning services include retirement, estate, and tax planning; insurance;investing; employee benefit developing; and college funding. Fora free tip sheet on diversifying your portfolio, call 212-221-7067 ore-mail info@gassmangolodny.com.