When Fortune Doesn’t Favor the Bold: Perils of Volatility for Wealth Growth and Preservation

Abstract

Successful entrepreneurs and executives often hold much of their wealth in a highly appreciated single stock and thereby face a difficult financial dilemma. On the one hand, the high idiosyncratic volatility of a concentrated single stock position can lead to significant risk of catastrophic losses; on the other hand, selling the stock can result in an immediate and punitive tax burden. This article develops an analytical framework for evaluating this choice and explains how it relates to classic betting strategies and economic theory. For many investors, a full and immediate liquidation of their appreciated single stock might be optimal from the perspective of long-run wealth growth and preservation. In fact, in the absence of diversification, most investors must expect catastrophic losses of wealth over reasonable investment horizons. For investors reluctant to incur an upfront tax burden, tax-efficient techniques for disposing of an appreciated single stock might strike the balance between the urgency to diversify concentrated risk and aversion to taxes. Whereas for median and mode cumulative wealth, the primary effect likely comes from diversification, be it tax efficient or not, for mean cumulative wealth, the tax efficiency of diversification can yield a tangible improvement.