The Concentrated Low-Basis Position
Your client, 58 and single, has $9.4M: $5.8M in her employer's stock (61.7%), acquired over 22 years with a $600,000 basis, and $3.6M in a diversified 70/30 portfolio. She plans to leave the company in 24 months and begin $250,000/year of portfolio withdrawals at 60. The stock has 34% volatility versus 16% for global equity, with correlation 0.55. Her all-in long-term capital gains rate is 28.8%. The company imposes no restrictions on hedging. A banker has offered a zero-premium 24-month collar (put at 85%, call at 125%) on up to 40% of the shares, and an exchange fund with a seven-year lockup and a 0.9% annual fee. She says she 'cannot afford to sell at a discount and cannot afford another 2008.'
1. Quantify how much of the portfolio's risk the single stock generates, and explain why the dollar figure understates the problem.
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Risk contribution. With w = 0.617, σ_stock = 0.34, σ_other = 0.16, ρ = 0.55:
- Variance = (0.617²)(0.34²) + (0.383²)(0.16²) + 2(0.617)(0.383)(0.55)(0.34)(0.16) = 0.04401 + 0.00376 + 0.01414 = 0.06191 → σ = 24.9%.
- Covariance of the stock with the portfolio = 0.617(0.34²) + 0.383(0.55)(0.34)(0.16) = 0.08279.
- Marginal contribution = 0.08279/0.2488 = 0.3327; risk contribution = 0.617 × 0.3327 = 0.2053 - 82.5% of total portfolio volatility from 61.7% of the assets.
Why that understates it. The $5.8M is also her human capital - same employer, same industry, same cycle. A 50% decline removes $2.9M, i.e. 31% of the total portfolio, against $250,000/year of planned withdrawals. And the 0.55 correlation means the other $3.6M barely helps: it contributes only 17.5% of the risk. Diversification elsewhere is not an offset; it is a rounding error.
2. Compare full sale to a 15% target, a staged sale, the collar and the exchange fund. What do you recommend?
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Full sale to a 15% target ($1.41M). Sell $4.39M; gain portion = $4.39M × (5.2/5.8 = 89.7%) = $3.94M; tax at 28.8% = $1.13M; net $3.26M reinvested. Assets fall to $8.27M, in which the stock is 17% - the target moves because the tax is a real leakage. Maximum risk reduction per dollar of tax, and it converts an unknown risk into a known, paid cost.
Staged sale over 24–36 months. About $1.46M per year. Defers part of the $1.13M, spreads execution and price risk, and - critically - completes while she still has salary and benefits, before withdrawals begin. This is the default recommendation.
Collar at 85/125 on 40% ($2.32M notional). Zero premium, but the floor protects only 15% of $2.32M = $348k, or 3.7% of the $9.4M portfolio, against an 82.5% risk share; and the call gives away all upside above 125%. It neither diversifies nor reduces tax - it rents 24 months. Useful only as a bridge over the staged programme.
Exchange fund. Defers tax but adds a seven-year lockup, 0.9% a year and imperfect diversification to a client whose core problem is already concentrated, illiquid risk. Reject.
Recommendation: staged sale to 15% over 24 months, collared on the un-sold half during the programme, with the first three years of spending funded from proceeds so no stock is sold at a low price to meet cash needs.
3. What would cause you to change this plan?
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Pre-committed triggers, agreed in writing now so they are not relitigated under stress:
- Price: a 30% fall cuts the embedded gain to $3.46M and the tax to roughly $996k while also cutting the risk. The after-tax cost of diversifying falls, so the case for accelerating strengthens. The perverse instinct - holding on to 'get back to even' - is exactly what the trigger exists to prevent.
- Corporate event: tender offer, merger, buyback or lock-up expiry. Tax and timing analysis must be redone within days.
- Basis step-up: she is single; death resets basis and would make any pre-death sale a waste of ~$1.1M. Estate intent and health changes belong on the monitoring list.
- Charitable intent: if genuinely philanthropic, low-basis shares to a donor-advised fund or CRT eliminate the gain - but only if the intent is real, not manufactured to dodge the tax.
- Fundamental deterioration or blackout windows: these change sequencing, not the destination.
Document the triggers alongside the recommendation so that future action is a review of agreed criteria rather than a fresh argument.