From Concentration to Diversification: Balancing Taxes, Risk and Performance

Wealth managers often work with high-net-worth (HNW) individuals who hold a considerable amount of one company’s stock (company executives, for example). This results in a very concentrated portfolio, which can come with high investment risk. Selling these stocks can mitigate the investment risk but may also trigger a considerable tax liability for large realized gains. By reinvesting the embedded gains into a diversified basket of assets, however, the client may be able to reverse the tax drag. Our simulation-based study found that, under the same market conditions, faster transitions reduced the net tax impact by more than 80 basis points (bps) annually with similar total portfolio returns.¹

To illustrate how scenario analysis can help with making decisions on balancing trade-offs of risk, tax and after-tax performance,² we look at a hypothetical case of a U.S.-based HNW individual, the executive of a company, with significant company stock holdings:³

• We assume the stock price has risen after vesting, resulting in USD 1.5 million of unrealized gains in a USD 2.5 million portfolio, at the start of the simulated transition.
• The legacy stock portfolio has a tracking error of 20.3% relative to the MSCI USA Index. Our target is a diversified equity portfolio with tracking error below 2%, which we consider the threshold for a successful transition.
• We examined annual gain budgets from USD 100,000 to USD 1.2 million with quarterly portfolio rebalances over a five-year transition period.⁴
• The scenario-analysis framework used historical performance deciles of the MSCI USA Index to reflect a wide range of potential stock outcomes and avoid selection bias.

The deciles were constructed by ranking constituents of the MSCI USA Index based on their performance between Dec. 31, 2019, and Jan. 1, 2025. The table reports the average return and median volatility for the assets within each decile. Over the same period, the MSCI USA Index delivered an annualized return of 14% with volatility of 21.7%. 

To begin our scenario analysis, we examined the market conditions and potential expectations from the legacy stock. The study is based on data from a recent five-year period, where the market trended upward, but many stocks experienced marked drawdowns.

The charts show the performance, risk and tax dimensions of simulated transition strategies between Dec. 31, 2019, and Jan. 1, 2025. An initial rebalance is followed by quarterly rebalances. The net tax impact models both the taxes and benefits of realized losses, relative to the starting portfolio value of USD 2.5 million. 

The selection of a gain budget proved to be critical, but no single choice can simultaneously optimize risk reduction, portfolio performance and tax efficiency. Nevertheless, the transition’s primary goal in this trilemma was to reduce tracking error until we obtained a well-diversified target portfolio. The expected time taken to hit the 2% tracking-error target was a key outcome for the strategy. 

The chart shows the end state of different transition strategies after a five-year transition period. Columns are annotated to indicate cases in which the portfolio did not reach the 2% tracking-error target within the five-year transition window.

Shifting market conditions can create an asymmetrical challenge for wealth managers: In favorable conditions, clients may prefer a slower transition (that is, using a lower gain budget) while their portfolio outperforms, even at the cost of higher risk. In contrast, higher tax efficiency may be insufficient to outweigh the underperformance of the target benchmark and/or major portfolio losses for a client. A low gain budget may be inadequate to complete the transition in five years, given changing conditions, even if gains stayed constant, which is rarely the case. 

Each dot represents the end state of each five-year transition strategy that achieved the 2% tracking-error target. In the simulation, higher gain budgets (green-colored) resulted in the best combination between tax efficiency and benchmark-relative performance. 

In the downward and sideways-trending deciles of the simulated scenarios, the net tax impact was similar regardless of the gain budget. In these deciles, higher gain budgets and faster transitions toward the benchmark are especially beneficial. By reallocating from a lagging stock into a diversified benchmark portfolio, the likelihood of switching to stronger-performing components increased, which elevated performance. 

In the upward-trending deciles, the difference between higher and lower gain-budget outcomes was clearer. Strategies using higher gain budgets achieved an average annual tax reduction of 80 bps when compared with lower-gain-budget strategies that delivered similar performance. With higher gain budgets, the legacy positions were closed earlier in the simulated strategies so that embedded gains were replaced with new positions. In the simulations, we found that during the 2022-2023 market correction, strategies that realized more losses at that time achieved better terminal outcomes. These opportunities translated into an improved net tax impact by realizing losses on weaker performers and enhancing portfolio value with stronger ones. The replacements proved to be new gains by 2025 while keeping performance steady.

Using historical scenario-based simulations, we have shown that realized-gain-budget selection is critical when designing a transition strategy from a concentrated stock portfolio to diversified, broad-market exposure. Additionally, we analyzed how portfolio outcomes may be shaped by the stock’s benchmark-relative performance during the transition. While there is no one-size-fits-all solution, the guidelines we’ve provided are an example of guardrails that can help wealth managers construct a transition strategy that balances after-tax performance, concentration risk and portfolio volatility.