Tag: risky investments

  • Concentrated Stock Positions Are Risky

    Concentrated Stock Positions Are Risky

    Concentrated Stock Positions Are Risky
    The worst-case scenario of holding a concentrated stock position is that the chosen company can bankrupt and the stock value drops to zero.

    Concentrated stock positions occur when you as an investor own shares of one stock in a big percentage of your portfolio. So your capital is concentrated in a single position. How big is that percentage? It depends on the size of your portfolio and the volatility of the stock. But concentrated stock positions commonly occur when that stock represents 10% or more of your overall portfolio. 

    The modern theory says that it can be any position size that may hurt your investment plan. So, we won’t be wrong if we say that concentrated stock positions are any portion in one single stock in your portfolio that have a major influence on your overall portfolio no matter if it is 5% or 55%. Generally, it is a position size that can destroy your financial goals.

    But nothing is so bad as it looks at first glance. Many people created their wealth by holding a single stock. So many families built a fortune in this way. The value of that stock grew heavily over time and the members of such a family inherit these concentrated stock positions, a large one that consists of just one stock.

    Don’t matter how the concentrated stock positions are earned, they always represent an unbalanced allocation of investments. Since the holder of such a portfolio needs to reduce risk, it is essential to understand it and maintain it properly. There are several strategies very suitable for handling concentrated stock positions.

    Strategies for handling concentrated stock positions 

    Have you ever heard a saying: “Concentrated wealth makes people wealthy, but diversified wealth keeps them wealthy.” It’s kind of credo among investors. Concentrated stock positions are challenging for managing. They have great risk potential included. So for that to be done, the investor needs a proper strategy.

    One of the most common strategies is selling the part of these concentrated stock positions or the whole holding on it. To be honest, that is the simplest way to reduce the concentration on the stock. 

    But there are some that may occur, for example, the capital gains tax is connected with selling. In order to decrease the tax, you don’t need to sell the whole position. Sell it in the parts. For instance, you can define an amount and sell one by one quarterly. Of course, you can choose a different time frame but the goal will stay the same, to reduce the concentrated stock position since you would like to reduce the exposure also. Depending on the position’s value it may take a few years unless the whole process is done. Some experts claim that 3 to 5 years is the optimal time frame for that.

    So you have two choices with this strategy: to sell the stock immediately or in portions over time.

    Hedge the position – a strategy for handling concentrated stock positions

    Those are actually two strategies but we’ll put them in one because they are connected. This is a bit of a complicated strategy but an effective one. Everyone wants to protect the owned stock against drops. You can do it by using options. So, think about the buying of put options as a kind of insurance against the potential losses in your stock. When you buy a protective put option, you’ll have the right to sell your stock, the whole or part of it, at a predetermined price. Don’t be worried if the stock price increases above the predetermined price. Your option will expire worthlessly and you’ll still hold your stock.

    This strategy is quite good if you need short-term protection, so think twice are you willing to use it because over the long run this strategy may cost you a lot.

    Also, you may sell covered call options. The strike price should be above the current market price. That will give you an extra income but the smallest protection against total loss if the stock price decreases significantly. Moreover, you’ll not benefit from price appreciation if you use covered call options as a strategy to handle concentrated stock positions. 

    Maybe you can use covered call options as a part of a well-organized selling process based on the market movements. Meanwhile, you get paid the premium.

    Diversifying

    It doesn’t mean you’ll make some small adjustments to your portfolios. Your main goal is to reduce the volatility that a concentrated position generates. And you cannot do that randomly, this diversification has to be exact.

    As we said, you can sell this large position at once but there are some problems that may arise. The most important is that you can reduce the value of your overall portfolio by doing so. For example, if you sell the whole position at once that could cause the stock price to drop in value. 

    Sometimes such a decision can be emotionally difficult. So, a staged sale can be a way to avoid emotional reactions when selling a large position. You can do this if you determine the number of shares of the stock you want to sell by a particular date.

    For example, you want to sell 21,000 shares of the stock over the next 21 months. And you decide to sell shares every quarter. There will be seven sales during this period, right? At the end of each quarter, you are selling 3,000 shares. This will not disturb you a lot, you have a schedule, your emotions will be under control, you don’t even have to think about the market fluctuation.

    Use the exchange fund 

    This method is useful when you find other investors in the same situation with concentrated stock positions and who want to diversify as you do. What investors have to do? What are their options? They can join their shares into a partnership where each investor gets a proportional share of that exchange fund. Since the stocks are not the same, each shareholder will have a portfolio of different stocks. That will provide diversification. The additional advantage of this method is that it provides the deferral of taxes. 

    The straightforward approach to diversify the concentrated stock positions

    It is rebalancing with a completion fund. We describe it above. It is simply selling smaller parts of your position over time. You can use the money you got to buy some other asset and have a more diversified portfolio. That’s how a completion fund operates. But as a difference from exchange funds, you are in control of your stock.

    For example, you own $10 million worth stock, and you want to reduce the exposure to this stock. But you would rather sell part of your position because if you sell $10 million in one transaction the taxes you have to pay would be expensive. So, you prefer to sell  20% of the position every 6 months, and use that money to diversify into other assets. Over time you’ll have a fully diversified portfolio adjusted to your risk tolerance. 

    Bottom line

    Some wealth transfer strategies could benefit you. For example, family gifting strategies, and charity gifting strategies such as direct gifts, foundation, or trusts.

    The most important is to have peace of mind. Holding such a great but only one stock that generated money for many generations is a great responsibility. But that kind of portfolio is very volatile and risky. So you have to be smart and find the concentrated stock positions exit strategy suitable for your circumstances and goals. Your chosen strategy has to increase your overall wealth. 

    These strategies can reduce risks, reduce the tax of reducing the position. They are worth seeking. If you still are not sure which strategy to choose, find a professional financial advisor.

  • What is Riskier Bonds or Stocks?

    What is Riskier Bonds or Stocks?

    (Updated October 2021)

    What is Riskier, Bonds or Stocks?
    In some scenarios, bonds are riskier than stocks. The main problem is how to run your investments stable but not cutting the growth stocks have to give.

    Do you think the stocks are riskier than bonds? Well, stock prices are more volatile than bonds, that’s the truth. Also, bonds are paying fixed income. What else is on the bond side? Well, not much. Maybe these two is all since bonds could be riskier than stocks. The whole truth is that bonds are very risky for the companies, but at the same time, less risky for investors. Speaking about stocks, they are less risky for the companies but for investors, they can be extremely risky.

    So, why do so many people think that bonds are less risky? We have to solve this dilemma: what is riskier, bonds or stocks.

    The most and least risky investments

    There are so many factors that have an influence on how some investment will perform. Honestly, all investments carry some level of risk. Speaking about bonds, they are under the great influence of inflation while stock investors may not feel it so much. Stocks have some other kind of risks, for example, liquidity risk. Such a problem bond investments don’t have.

    Firstly, stocks are the riskiest investments, but they also give excellent potential for high returns. Stocks or equity investments cover stocks and stock mutual funds.

    Bonds or Fixed Income Investments cover bonds and bond mutual funds. They’re less risky than stocks but generate lower returns than stocks.

    The third-place belongs to cash or certificates of deposit, money market funds, Treasury bills, and similar investments. They are giving lower returns than stocks or bonds but carry a little risk also.

    What are stocks and bonds?

    To understand what is riskier, bonds or stocks we have to make clear what each of them is. There are two main concepts of how companies can raise money to finance their businesses. One is to issue stocks and the other is to issue the bonds. 

    Stocks and equity are the same. Both define ownership in a company and can be traded on the stock exchanges. Equity defines ownership of assets after the debt is paid off, so it is a bit broader term. Stock relates to traded equity. Equity also means stocks or shares.

    In the stock market tongue, equity and stocks are the same.

    Stocks

    Stocks will give you an ownership stake in the profits of the business, but without the promise of payment. That’s why stocks are riskier. The companies may decide to pay dividends but nothing else is an obligation. While holding the stocks the value of your investment will vary related to the company’s profit. Stocks are also dependent on investors’ sentiment and confidence. Anyway, stocks are safer for companies since they are a sure way to raise the money needed to maintain business. For investors, stocks are riskier since the companies don’t have any obligation to provide any kind of return. If the company is growing and rising profit, investors will obtain capital gains.

    Bonds

    Bonds are parts of debt issued by companies and transformed into assets to be able to trade in the market. Bonds give fixed interest rates also called coupons to bondholders. The companies have to pay the interest rate before any dividend to stockholders. Otherwise, the bonds go into default. Also, bonds are conversely related to interest rates, meaning, when rates go up, bond prices drop. 

    Can you see now? How to answer the question of what is riskier, bonds or stocks? For investors, stocks are a riskier investment, for the companies, the bonds are riskier. 

    Bonds vs Stocks

    The majority of investments can be classified as bond investments or stock investments. In stock investment, you are buying an asset and your profit depends on the performance of that asset. If you buy a y a thousand shares of Tesla, your profit is based upon the stock dividend which Tesla pays (if any) and upon the fluctuation of the value of Tesla shares.

    In a bond investment, you actually loan money to a company or a government. With a bond investment, your profit is not related to the performance of the company. If you buy a $2,000 bond from Tesla, for example,  and the company earns a record profit, your profit will be the same as if Tesla didn’t make a profit at all. But here is the risk involved with the bond investment. What if the company is unable to pay back the debt? You can lose all your investment.

    Stock investment is recognized as a higher risk. But risk makes a profit, therefore you will earn a higher return over the long term. 

    So, what is riskier, bonds or stocks?

    Risks and rewards of stocks investments

    Stock investments offer higher risks but greater rewards. A lot of things influence that. An increased sales, for example, or market share, or any improvement or development of the company’s business, literally anything can shift the stock price and skyrocket it. So, investors can earn by selling them or by receiving the dividends.  

    Any company can succeed or stumble. That’s the reason why nobody should invest in just one company. Do you know the saying: Never put all eggs into one basket? But if you hold stocks from several companies you will ensure high returns over the long term. 

    But, so many investors couldn’t watch the unfortunate events without selling their stocks at a loss. 

    Well, if you don’t have a stomach for that just stay away from the market or, which is a better choice, diversify your investment portfolio. Add some bonds-based investments, that will help you when the stock market gets rough. Moreover, a well-diversified portfolio will give you a bumper by providing lower volatility and calm play. So, you will not be forced to sell your investments and feel stress while making decisions. 

    Bottom line

    So, do you have the answer what is riskier, bonds or stocks?
    Yes, stock prices fluctuate more than the prices of bonds but that doesn’t necessarily mean more risk for the investor. There are a lot of cases when bonds are riskier than stocks.

    For example, over a high inflationary period when inflation is surging quickly, the bond price can be damaged, decreased. The inflation will decrease the value of payments, and the bonds will mature less valuable.  

    On the contrary, stocks can boost their prices during inflation. The companies could raise prices of their products and increase their profits. That would raise the value of their stock, even higher than the inflation rate. 

    Can you see how the bonds might be riskier investments than stocks?

    During the regular economic conditions, stocks could be much riskier than bonds.

    Stock prices could sink sharply. Hold! Don’t sell! Wait for a while, wait for a stock to bounce back in price. And you know what, when the stock prices are falling, there is no better moment to buy them and hold. Just pick a well-established company. 

    The point is that bonds are not always the safest asset. They can be very risky. In some scenarios, stocks can be a much safer choice. 

    Savvy investors will buy both to diversify portfolios. Of course, how many of each you will hold isn’t set in stone. You can change it over your lifetime as many times as you want to reach your goals and earn a profit.