.png)
.png)
Diversification is a fundamental principle of investing, but for corporate executives with exposure to Company Stock on multiple levels, it's a necessity to avoid taking on excessive risk that jeopardizes achieving financial goals.
But, with stocks reaching all-time highs, it is understandable that many executives are hesitant to sell and diversify their Company Stock position. Optimistic projections, tax bills and minimum holding requirements are all reasons that executives choose to hold Company Stock.
Since there is often a financial and emotional cost associated with diversifying a concentrated Company Stock position, executives often ask a fundamental question:
Will selling my Company Stock and diversifying the proceeds improve the likelihood of achieving my financial goal(s)?
This insightful and direct question is often not met with a deserving response. When the benefits of diversification are dared to be questioned, the responses are often shallow, generic and presented with an air of condescension as to discourage additional questions.
Fortunately, finance is a science - albeit a social one - that provides methods for helping us address such an insightful question on an individual level.
Before exploring these methods through the case study of Rebecca, an Executive at a large retailer, let's summarize some key academic findings on the subject of diversification and portfolio theory.
Portfolio Theory: Diversification and Pricing Risk
Before Harry Markowitz's 1952 paper, "Portfolio Selection" introduced the benefits of diversification, the optimal portfolio was believed to consist of securities with the highest expected return. It was assumed that by holding several securities, the "law of averages" would result in an actual return approximating the expected return.
Markowitz emphasized that the "law of averages" is insufficient to managing the difference between expected and actual returns. He eloquently shows that it's necessary to include securities that are NOT fully correlated to reduce the gap between expected and actual returns.
While Markowitz defined risk as the degree of dispersion around an expected outcome, or standard deviation, William Sharpe (1964) redefined risk in terms of an asset’s price sensitivity to a diversified market portfolio.
Sharpe's Capital Asset Pricing Model (CAPM) states that an asset's price is determined solely by its price sensitivity to the market portfolio, not by its individual volatility, or standard deviation. In other words, expected return is not rewarded for holding idiosyncratic risk that is unique to a specific company, sector or asset class.
Subsequent studies sought to refine the CAPM’s explanatory power. Robert Merton's Intertemporal CAPM (1973) stated that investors may opt for a less-than-optimal portfolio in exchange for a hedge during certain events such as a recession. Eugene Fama and Kenneth French (1992) found additional non-diversifiable risk factors, such as valuation and size, determine an asset's price.
In sum, the two key takeaways are:
By including assets that are not fully correlated, a portfolio’s risk can be reduced without sacrificing expected returns.
An asset's price is determined by its price sensitivity to the overall market portfolio, not the price sensitivity to idiosyncratic risks specific to a company, sector or asset class.
Now, let's review the case study of Rebecca to illustrate these theoretical concepts and introduce how to address real world obstacles such as taxes.
Case Study: Balancing Taxes and Diversification
Rebecca, an executive at a large retailer, holds $500,000 in Company Stock and her goal is to grow it to $1,000,000 in 20 years. While she recognizes that diversification could help her reach this goal, she's concerned about the significant tax bill she would face if she sold her highly appreciated Company Stock. The question that Rebecca wants help addressing is:
Will diversifying my Company Stock improve the likelihood that I'll achieve my financial goal(s)?
The first step in her analysis is to define her expectations for both the Company Stock and the Diversified Portfolio—specifically their expected return and standard deviation.
Exhibit 1: Risk and Return Expectations
![Yield = Div Yield + Buyback Yield; Growth = Avg 10-Yr Historical Earnings Growth; Valuation Change = [(10-Yr Average Price to Earnings Ratio/Current Price to Earnings Ratio)^1/10] - 1; For simplicity, SP 500 Index is used as a proxy for the Diversified Portfolio.](https://static.wixstatic.com/media/a2bbce_33437aff8ca54ea78e62ac3bcca883c8~mv2.jpg/v1/fill/w_631,h_142,al_c,q_80,enc_auto/a2bbce_33437aff8ca54ea78e62ac3bcca883c8~mv2.jpg)
The above expectations express a belief that the Diversified Portfolio is slightly more efficient. It has a higher expected return and lower level of risk compared to the Company Stock.
If there were no taxes, the decision to diversify would be straightforward. The Monte Carlo simulation shows that the Diversified Portfolio offers a 55% chance of success, compared to 41% for holding the Company Stock (see below).
Exhibit 2: Monte Carlo Simulation Results without Taxes
However, Rebecca faces a $119,000 tax bill today if she diversifies ($500,000 x 23.8%). If she holds the Company Stock, she can defer this tax bill for 20 years. To account for the tax impact, we adjust the starting amount of each portfolio:
For Company Stock, we reduce it by the present value of the deferred tax bill (FV = $119,000, N = 20 years, Discount Rate = 4.2%).
For the Diversified Portfolio, we reduce the starting amount by $119,000 as the tax is paid today.
Exhibit 3: Monte Carlo Simulation Results with Taxes
Even with the accelerated tax cost, does the Diversified Portfolio improve Rebecca’s chances of achieving her goal?
Yes, I'd recommend Rebecca sell the Company Stock, pay the tax bill and diversify the proceeds. Even though the Probability of Success is similar once taxes are accounted the model is likely underestimating the risk for the Individual Company Stock for 3 reasons:
Flawed Risk Metric: Our risk metric, standard deviation, assumes a normal distribution of returns. In reality, returns are not normally distributed with undiversified holdings having more extreme outcomes (i.e. fatter tails, negative kurtosis).
Success is not Binary: The Monte Carlo simulation treats success as binary, but in less favorable scenarios, the diversified portfolio shows much higher end-of-period values, as seen in the 25th and 50th percentile outcomes.
Risk and Return Predictions: It’s extremely difficult to predict asset returns and risks with certainty, and it’s even more difficult to do so for an individual stock—unless you have an information advantage.
The Takeaway
The key takeaway is that diversification provides investors with significant benefits in the form of higher expected returns for a fixed amount of risk, but for corporate executives it's important to formulate a customized plan that accounts for the tax cost, overall exposure to the Company Stock (e.g. human capital, holding requirements) and the corporate executive's specific goals. In some cases, the cost of diversification may exceed the expected benefits.
Fortunately, as we've briefly discussed, there are methods to assess the potential benefits and costs in order to make an informed decision based on an investor's unique situation.
Thanks for reading,
Mark Chisenhall, CFA, MBA
Financial Advisor | Founder of Taurus Financial Planning
Taurus Financial Planning is a Fee-Only Wealth Management firm based in Bentonville, AR. The firm offers comprehensive financial planning, tax planning and investment management to corporate executives across the country.
Taurus Financial Planning is a Registered Investment Advisor with the State of Arkansas. This information is provided as a guide to assist you in your financial planning. The specific examples are provided for illustration purposes only and are not representative of specific investments or guarantees of future returns. Please consult with a professional for specific questions regarding your particular situation. If there is any error or inconsistency between this document and the official company plan documents, your company plan documents will govern.
This publication is for informational purposes only and is not intended as tax, accounting or legal advice or as an offer or solicitation of an offer to buy or sell or as an endorsement of any company security fund or other securities or non securities offering. This publication should not be relied upon as the sole factor in an investment making decision. Past performance is no indication of future results. Investment in securities involves significant risk and has the potential for partial or complete loss of funds invested. It should not be assumed that any recommendations made by the Author, in the future, will be profitable or equal the performance noted in this publication.
.png)