Maintaining a single, large stock position has produced tremendous wealth for certain families. It’s a strategy that comes with substantial risks, however.
Investment advisors universally recommend holding a diversified portfolio because any one investment can go down at any time. In some cases, a stock that has suffered a significant decline might not see its price recover for months or years—or ever.
Often, a sentimental attachment or extreme confidence in a company’s future makes investors unwilling to part with their shares. Also, if the stock has appreciated considerably, investors may not wish to incur a large capital gains tax bill from selling. However, to generate cash for spending, a portion of any such concentrated holding will likely have to be liquidated at some point.
Faced with this dilemma, some investors look to support their lifestyles by using margin—in other words, borrowing against the stock.
How Margin Can Help (or Hurt) Single-Stock Investors
Simply put, margin means borrowing money and using an investment as collateral. By borrowing, an investor can generate liquidity not subject to income or capital gains taxation. However, the interest expense may be nondeductible if no investment income is being generated.
What’s more, the collateral shares are subject to margin calls. When the value of a stock goes down, the borrower may be forced by the lending institution to sell some of the stock and use the proceeds to pay down a portion of the margin loan, keeping their loan-to-equity value at a required level. Given recent market volatility and interest rate increases by the Federal Reserve, many families who have borrowed on margin have found themselves in a very tough situation. Not only has their personal net worth declined, but borrowing has become more costly. There have also been reports of executives who have borrowed against their company stock facing repeated margin calls as their shares tumbled.1
In short, maintaining margin debit balances can be dangerous to an investor’s financial well-being. So, before pursuing a margin strategy as a means of keeping a concentrated stock position to support spending, it’s important to know not only the benefits, but also the risks. Factors to consider include:
- The amount of the borrowing as a percentage of the stock value
- Current and forecasted interest rates applying to the margin loan
- The prospects for future performance of the underlying company and its stock
- Your spending needs going forward
Case Study: The $100 Million Question
Let’s consider an example of a 60-year-old couple who received a single stock position2 (with a zero cost basis) from the sale of a business. The current value of the investment is $100 million.
They intend to hold the position for the long term and are considering carrying it on margin to meet their lifestyle spending needs of $1 million per year, adjusted for inflation.3 They would like their children to inherit the entire position, with the goal of achieving a step-up in basis at the time of inheritance.
When advising a couple in this situation, we would first calculate their core capital using Bernstein’s Wealth Forecasting System.SM We define core capital as the amount of assets needed today to support future lifestyle spending with a high degree of confidence.4 Note that we’d take this approach whether the pair intend to keep as much of their stock position as possible or if they aim to strategically diversify out of it.
Hold onto the Stock
Scenario A: No Margin Loan
How much will the couple have in “spendable dollars” if they don’t use a margin loan, and instead, sell off their stock position gradually over the years as needed for spending cash? Assuming an effective federal capital gains tax rate of 23.8% (with no state income taxes) and no change in stock price, the couple would have $76.2 million of their original $100 million to spend.
Is this amount sufficient to fund their annual $1 million in lifestyle spending? Unfortunately, no. We quantify core capital in this “no margin loan” scenario to be $157 million in concentrated stock, $57 million more than the couple currently has.
That’s because the amounts sold to fund lifestyle spending will be subject to long-term capital gains tax. Plus, the absence of a margin loan will mean that the holding is shrinking by the $1 million of spending per year adjusted for inflation. In addition, there is an increased likelihood that market movements or company-specific factors could potentially result in a lower price for the stock.
Scenario B: Margin Loan Used
Now let’s assume the couple takes out a margin loan, and their initial rate of borrowing is 4%. If they follow through with this plan, how much will they have in spendable dollars?
With a margin loan, the total spendable amount for the life of the investment is reduced by Federal Reserve regulations and the lending institutions’ own risk parameters, which restrict how much can be borrowed on a concentrated stock position up to a certain percentage of the stock’s value. Assuming this limit is 25%,5 the initial spendable amount enabled by margin borrowing would be $25 million.
Keep in mind that the couple would not take out a loan on margin for $25 million all at once. They would begin with the $1 million needed for the first year, and increase their margin balance each subsequent year by the same amount adjusted for inflation to fund their spending.
Using a margin loan to support inflation-adjusted spending, plus annual interest costs, can be an effective way to avoid selling stock right away, particularly if interest rates are low. We looked at what could happen if the initial margin interest rate of 4.0% gradually increased to 5.0% over several years and remained at this level thereafter. We determined that the couple’s overall net portfolio after 30 years (in the median case, or in typical markets) could be $222 million. This compares to an overall portfolio of $183 million had they not incurred the margin loan but rather sold stock as needed to satisfy their spending requirements.
The margin loan strategy allows the couple to accumulate approximately 21% more wealth, so it’s tempting to settle on this as the right move (Display).6 However, given the risks inherent in the strategy, it’s also a good idea to consider whether selling out of the concentrated position into a globally diversified portfolio makes more sense.
Diversify the Concentrated Position
In this case, the couple would sell out of the concentrated stock completely over time and reinvest the proceeds into a globally diversified portfolio.
To make a useful comparison, we would assume a 20-year time frame for selling the stock,7 with roughly equal amounts sold per year. As in Scenario A, the portions sold would be subject to long-term capital gains taxes. However, diversifying would be sufficient to allow the couple to spend $1 million per year.
Here, where the after-tax sale proceeds will be gradually invested in a globally diversified equity portfolio, we calculate the couple’s core capital requirement to be $74 million pretax—a level they could meet today, leaving them with surplus capital. In addition, they would not carry a margin debit, nor would they be subject to margin calls.
Even more significant is the downside protection that diversification affords. In the event of very poor markets (a rarer, 95th percentile event), holding onto the stock as in Scenarios A and B would rapidly diminish their portfolio’s value. For example, at the end of just 15 years, they could expect a portfolio worth $13.7 million (Scenario A – no margin loan) or $4.9 million (Scenario B – with the margin loan). Strategically diversifying out of the stock would limit their risk, leaving them a portfolio totaling $30.4 million. And this dispersion would only increase further over time.
Of course, should markets take an extended turn for the worse—hypothetically, multiple years of poor performance for the underlying stock—any of these strategies would need to be reevaluated.
Margin Is Complicated. Don’t Go It Alone.
The intricacies of margin borrowing, particularly when it comes to maintaining a concentrated stock position, can’t be fully explained in one blog post. Talk to your Bernstein Advisor to find out more about strategies that can work for you.
- Austin Cooke
- Vice President—Wealth Strategies Group
- Elizabeth Sohmer, CFA
- Associate Director—Institute for Executives and Business Owners
- Richard Weaver
- National Director, Executive Services—Wealth Strategies Group
2 Stock modeled with the following initial characteristics: Volatility: 25%, Dividend: $0, Beta: 1.
3 Inflation adjustment for spending is based on our median inflation projections in 10,000 simulated trials, each consisting of 50-year periods. This spending figure reflects AB’s estimates, and the capital market conditions as of June 30, 2022. Median 50-year growth rate is 3.2%.
4 Bernstein’s wealth forecasting models simulate 10,000 plausible future paths of returns for each asset class, with the goal of achieving 90% or 95% confidence that the core capital amount will allow clients to spend what they need each year for the rest of their lives and not run out of money—even accounting for potential poor market returns, high inflation, and an unexpectedly long lifespan.
5 Our analysis took into consideration the risks of a margin call were the value of the stock to suffer a significant drop in future years.
6 Wealth values account for taxes when stock is sold. Analysis assumes no tax benefit from interest expense.
7 Selling the stock in equal amounts over a 20-year period allows the couple to achieve a 95% level of confidence of sustaining expenses over their lifetime.