Author: Kip Lytel, CFA
Montecito Capital Management
When someone inherits a taxable brokerage account, it often contains large positions in individual stocks accumulated over decades. These holdings frequently reflect the investment environment of the previous generation — a time when investors held concentrated positions in dominant American companies and allowed gains to compound over long periods.
Inheritance creates a rare tax opportunity: the step-up in cost basis. But it also creates something equally important — a strategic moment to reassess portfolio risk.
That opportunity may be particularly relevant in today’s market environment.
U.S. equities currently trade at valuation levels that sit well above long-term historical averages. The S&P 500’s forward price-to-earnings ratio has recently hovered in the low-to-mid-20s compared with a long-term historical average closer to 16–17. Cyclically adjusted valuation measures such as the Shiller CAPE ratio have also remained elevated relative to most periods over the past century.
While high valuations alone do not signal an imminent market decline, they do suggest that future returns may rely more heavily on earnings growth rather than multiple expansion.
At the same time, the global economic backdrop contains several sources of uncertainty that were largely absent during the multi-decade bull market that many legacy portfolios were built within.
Among them:
• Persistent geopolitical tensions across multiple regions
• Elevated government debt levels across major developed economies
• Ongoing shifts in global trade and supply chains
• Structural inflation pressures following years of monetary stimulus
Additionally, the U.S. dollar — the foundation of global financial markets is down 12% vs the Euro and faces long-term structural questions. Rising federal deficits, expanding debt issuance, and increasing geopolitical competition have led some economists to question whether the dollar will maintain the same level of dominance it has enjoyed since the post-World War II era.
Financial historians and market commentators have also noted that aspects of today’s environment echo earlier periods of financial excess. Rapid technological change, elevated leverage, and asset prices pushing beyond historical norms have appeared at multiple points throughout financial history. While today’s economy is vastly different from that of the 1930s, the lesson repeated across generations is that concentrated portfolios can become particularly vulnerable when market leadership narrows and valuations expand.
None of these factors necessarily imply that markets are on the brink of a downturn. But they do highlight why portfolio concentration risk becomes more dangerous during periods of elevated valuations and structural economic change.
For heirs inheriting large, concentrated stock positions, this environment reinforces the importance of diversification. Fortunately, the step-up in cost basis creates one of the rare moments in investing when diversification can be implemented with little or no tax consequence.
Used correctly, this moment allows heirs to restructure an inherited portfolio, reduce single-stock, or high concentrated equity exposure, and build a more resilient investment framework designed for the next generation of wealth stewardship.
Understanding the Step-Up in Basis:
Under U.S. tax law, most assets inherited from a deceased individual receive a new cost basis equal to their fair market value on the date of death.
Example:
Original purchase price: $25,000
Value at death: $350,000
New cost basis for the heir: $350,000
If the heir sells the stock immediately at $350,000, no capital gains tax is owed, because the appreciation occurred during the previous owner’s lifetime.
This reset creates a unique opportunity to reorganize an inherited portfolio without the normal tax consequences associated with selling appreciated assets.
Why This Is the Best Time to Diversify
1. Sell Concentrated Positions Without Capital Gains
Many inherited portfolios are heavily concentrated in:
• A single company
• Employer stock
• Legacy blue-chip names accumulated over decades
Normally selling these positions would trigger significant capital gains taxes. The step-up effectively erases those gains, allowing heirs to reduce concentration risk without tax friction.
2. Reduce Single-Stock Risk
Large individual stock positions can expose an investor to substantial volatility.
If 50% of a portfolio is tied to one company, the entire portfolio’s future becomes dependent on that company’s performance.
Diversifying into:
• broad U.S. equity exposure
• international markets
• bonds or fixed income
• real assets or alternatives helps reduce company-specific risk while maintaining market exposure.
3. Modernize the Portfolio Structure
Inherited portfolios often contain:
• high-expense legacy mutual funds
• overlapping stock positions
• outdated sector allocations
Using the step-up moment allows investors to rebuild the portfolio using lower-cost ETFs, modern asset allocation models, and more tax-efficient investment vehicles.
Why Concentration Risk Matters More in Late-Cycle Markets:
History shows that periods of elevated market valuations are often accompanied by increasingly narrow market leadership.
In the late 1960s and early 1970s, a small group of dominant growth companies known as the “Nifty Fifty” came to dominate portfolios, with investors believing these stocks could be held indefinitely regardless of valuation.
Similarly, during the technology bubble of the late 1990s, a relatively small group of technology companies drove a disproportionate share of market returns before valuations eventually corrected.
Today’s market also shows signs of concentration. In recent years, a small group of mega-cap technology companies has accounted for a significant portion of the S&P 500’s total return and now represents a substantial share of the index’s overall market capitalization. While these companies are highly profitable and fundamentally strong, concentration at the index level can create hidden portfolio risk when individual holdings become too large relative to the broader market.
For investors inheriting portfolios that may already be concentrated in a handful of legacy stocks, these conditions reinforce the importance of diversification.
The step-up in basis provides a rare chance to address that risk without the tax consequences that would normally accompany a major portfolio restructuring.
Diversification Means More Than Owning More Stocks
Another important consideration when restructuring an inherited portfolio is that diversification does not simply mean selling a few concentrated positions and reinvesting the proceeds into a larger basket of equities.
Many legacy portfolios were built during periods when equities delivered exceptional long-term returns. As a result, it is not uncommon for inherited portfolios to be composed almost entirely of stocks. In some cases, diversification simply meant holding several different companies within the same asset class. However, reallocating a concentrated position into a wider group of equities does not necessarily create meaningful diversification. While the individual company risk may decline, the portfolio remains heavily exposed to the same underlying driver: the equity market itself.
From a portfolio construction perspective, true diversification typically involves exposure to multiple asset classes that respond differently to economic conditions. This distinction becomes particularly important during the later stages of a long market cycle.
After extended bull markets, valuations often expand, market leadership narrows, and correlations across equities can increase during periods of stress. In these environments, simply owning more stocks may not provide the level of risk mitigation many investors expect.
For heirs restructuring inherited portfolios, this can be an ideal moment to broaden the investment framework beyond equities alone.
A more resilient portfolio structure often includes a range of asset classes designed to balance risk and return across different market environments.
These may include:
• Fixed income securities, which can provide stability and income during periods of equity volatility
• Convertible bonds, which offer a hybrid profile of income and equity participation
• Preferred shares, which often provide attractive yields with lower volatility than common stock
• Real estate investment trusts (REITs) that offer exposure to income-producing real assets
• Liquid alternative strategies, which may include long/short equity, market-neutral, or macro approaches designed to reduce correlation to traditional markets
• Precious metals, such as gold, which have historically served as potential hedges during periods of financial stress or currency debasement
• Multi-asset strategies, which dynamically allocate across global asset classes to help manage risk through changing economic cycles
The goal of incorporating these assets is not to eliminate equity exposure. Equities remain a key driver of long-term portfolio growth. Rather, the objective is to construct a portfolio that can participate in market upside while also maintaining resilience during periods of market stress.
For many investors inheriting concentrated stock portfolios, the step-up in cost basis creates a rare opportunity to build that broader structure without the tax friction that would normally accompany a significant portfolio transition.
Applying Wealth Management Strategies Used by Montecito Capital Management:
Firms such as Montecito Capital Management frequently view an inherited portfolio as a strategic reset point rather than something to simply hold unchanged. Further, we believe advisory fees should reflect the value actually being delivered. Rather than charging a management fee on the entire portfolio—as is common across much of the advisory industry—we take a more aligned approach. When working with inherited portfolios, we often leave portions of existing holdings intact if they remain appropriate for the client’s objectives. In those cases, our advisory fee is applied only to the portion of the portfolio where active portfolio construction, diversification strategies, or specialized investments are being implemented.
Assets that remain unchanged are not assessed an advisory fee. This structure helps ensure that our interests remain closely aligned with those of our clients: we are compensated for the work and strategies we introduce, while clients are not paying fees on assets that do not require ongoing advisory intervention.
Several portfolio principles commonly used in this approach include:
1. Concentration Reduction
Inherited positions are often trimmed or fully sold if they represent an outsized percentage of the portfolio.
The goal is to prevent any single position from dominating overall portfolio risk.
2. Core-Satellite Portfolio Design
Many advisors adopt a core-satellite strategy.
Core holdings
• Broad U.S. equity index funds
• International equity funds
• Fixed income exposure
These form the majority of the portfolio.
Satellite allocations
• diverse industry equity ETFs
• thematic opportunities
• liquid alternative investments
• loss buffer equity ETFs
• precious metals
This structure provides diversification while still allowing room for targeted investments.
3. Tax-Efficient Portfolio Construction
After the initial rebalancing using the stepped-up basis, the portfolio is often structured with an emphasis on:
• tax-efficient ETFs
• low portfolio turnover
• strategic rebalancing schedules
This approach helps reduce future taxable events while maintaining diversification.
4. Alignment with the Heir’s Personal Financial Plan
Another key principle is that the inherited portfolio should match the heir’s financial objectives, not the prior owner’s.
That means evaluating:
• time horizon
• income needs
• risk tolerance
• liquidity requirements
The result is a portfolio designed for the next generation of wealth stewardship.
The Key Takeaway:
The step-up in cost basis gives heirs a rare opportunity to restructure a portfolio without paying taxes on decades of appreciation.
Rather than inheriting a concentrated set of legacy holdings, many investors benefit from using this moment to:
• diversify the portfolio
• reduce single-stock risk
• modernize investment structures
• align investments with their own financial goals.
By applying portfolio strategies similar to those used by Montecito Capital Management, heirs can turn inheritance into a clean starting point for a more balanced and resilient long-term investment strategy.