NASAA Series 65, Uniform Investment Adviser Law ExaminationClient Investment Recommendations and StrategiesMedium
A client has a concentrated position in their employer's stock, which they received through an employee stock option plan. They are concerned about the substantial unsystematic risk this concentration poses to their overall wealth. Which strategy would be MOST effective in mitigating this risk?
- AImplementing a covered call strategy on the concentrated stock.
- BSelling a portion of the employer's stock and diversifying into other asset classes.
- CHolding the stock long-term to realize tax benefits on qualified dividends.
- DPurchasing protective puts on the concentrated stock.
Show answer & explanationAnswer & explanation
Correct answer: B. Selling a portion of the employer's stock and diversifying into other asset classes.
Unsystematic risk, or company-specific risk, is best mitigated through diversification. Selling a portion of the concentrated stock and reinvesting in a variety of other asset classes directly reduces this risk by spreading capital across different companies and industries.
Why the other options are wrong
- A. A covered call strategy generates income but only offers limited downside protection and does not reduce the fundamental unsystematic risk of concentration.
- C. Holding the stock long-term for tax benefits does not address or mitigate the inherent unsystematic risk of a concentrated position.
- D. Purchasing protective puts offers downside protection for the existing shares but does not eliminate the unsystematic risk of having a concentrated position; it's a hedging strategy, not a diversification strategy.
Mitigating Concentrated Stock Risk
Reducing the unsystematic risk associated with a large holding in a single stock, often through diversification or hedging strategies.
- Diversification (selling and reinvesting) is the most direct way to reduce unsystematic risk.
- Hedging (e.g., options) can protect against downside but doesn't eliminate concentration risk.
- Concentrated positions carry significant company-specific risk.
Memory trick: Diversify the basket, don't just patch a hole.