When Diversification Stinks
Most financial advisors would tell you that “you need to diversify” your holdings – each account individually – into a nice basket of well-mixed funds and ETFs.
Here’s why they’re all full of crap.
Each one of your investment accounts are for different goals and have different investment options, tax ramifications and liquidity issues. Lumping them all into one bucket of “I need all my stuff to be diversified,” leaves tons of money on the table. For example, if you have a Roth IRA (which we’ve discussed here, here, and here), you probably know that the proceeds from that account are 100% tax free for the rest of your life (assuming you follow a few simple rules). The funds are not taxable to anyone. Ever. Never ever ever. So, if your great-great-great-grandson were to inherit a part of your Roth IRA, he will pay $0 in tax. It’s that simple. So, that being said – how many tax-free dollars would you like? Depending on the goal, you might decide that your Roth IRA account is long term and you’re going to be aggressively growing this pot.
I was looking at a potential client’s list of assets last week, and her goal was to grow that account as fast as possible. Yet, an advisor at the bank had recommended some high-grade corporate and government bonds. Is that going to grow the account quickly? Not likely. Instead, perhaps she should make sure her highly volatile aggressive international emerging market corn future fund is there – big bang for her buck. (To wit: in no way would I recommend an international emerging market corn future fund- -it’s merely an example. In your aggressive account, be aggressive. B-E Aggressive. B-E-A-G-G-R-E-S-S-I-V-E). Make sense?
You Want Diversification
…but some cookie-cutter approach of diversifying every individual account isn’t going to help you reach your goal. Diversification in the right places is what matters. Those bonds I mentioned above? Fantastic for this woman’s shorter term needs, but horrible if she’s eyeing at retirement 25 years down the road.
What about your IRA? Well, since that money will be taxed at your full tax rate upon withdrawal, maybe paying attention to the tax rate is as important as having the right assets. In fact, you could sub optimally diversify this piece of your portfolio and still come out ahead with the right tax strategy. Diversification? Think about diversifying your tax structure!
Here’s an idea that will make everyone’s head spin. Many, and really I mean nearly all, of the financial advisors in the world who don’t manage 401(k) assets will sit down with you and put together a nice, pie chart portfolio within your 401(k) plan, right? Well, maybe the right thing is to have some money in your company stock. Company stock….isn’t that risky? I can be, but here’s the strategy (including how to mitigate the risk):
When you retire and own company stock within your 401(k), you have a unique tax strategy available to you, not available if you don’t own company stock. Let me explain: Let’s say you have a 401(k) balance of $500,000 when you retire. You avoided all the advice to “diversify” and kept investing in your company’s stock for 30 years. All-in-all, your cost basis is $100,000, the rest ($400,000) is gain. Here’s what you can do:
First, you can roll it to an IRA like the rest of your buddies are going to do. When you do that, you promise to Uncle Sam a nice portion of the funds as you make withdrawals for the rest of your life and your beneficiaries lives.
Or, you could be different:
Instead, you exercise a little-known strategy called net unrealized appreciation (NUA). When you execute NUA you withdrawal the entire balance of your 401(k) that’s company stock and put it in your brokerage (not IRA) account. When you do that, you pay ordinary income on the cost basis in the year you make the withdrawal (in the above example that’s $100,000 taxed at your normal rate). The remaining $400,000 is taxed as long-term capital gains (today between 0% and 20% depending on income). Let’s assume that’s 15% – you’d save about 25% or $100,000, in taxes. Plus, while you own the stock, you’ll receive dividends, can write options on it (as we discussed last week), or sell it and diversify then.
I must point out, NUA is exceptionally complex. There are many rules to follow, I’ve just pointed out a couple nice things. DO NOT ATTEMPT to do this without consulting a true professional who knows EXACTLY what to do and when to do it. Bad penalties for messing this up.
What about losing it all?
Isn’t single-stock risk…well…risky?” I say absolutely! You shouldn’t take that risk lightly. But, there’s a way to overcome that risk and protect your portfolio by using other strategies, such as stop losses or options.
In some 401k plans, after the disaster at Enron (among others), companies allowed you to place defensive measures into your 401k plan. Take advantage of those. Also, you could write options outside of your 401k plan to offset the risk of the stock inside of your plan. Once again….NUA? Not for beginners.
But there’s a bigger point here, and it isn’t company stock: cookie cutter asset allocation plans aren’t helpful. Diversification based on your goals and risk tolerance is the clear way to go.
Don’t just do what the herd tells you to do. If you take time to learn some of this stuff (don’t be afraid to ask about it), you can profit mightily by being tactical.
That should’ve stirred up some controversy. Whatcha think? Comment below, please!
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Does it have to be company stock to do this? Plain stock or some special company stock?
It doesn’t particularly matter to me though because.company stock isn’t an option in our 401(k) though. I wouldn’t do it anyway though… having my employment relying on my employer is enough risk for me.
Lance @ Money Life and More recently posted..How We Set Up My Girlfriend’s Budget
Lance: Yes, it has to be your company stock. Of course, I don’t mean to go off the deep end, just trying to make a point: There’s more to money than meets the eye. Kinda like my kid’s Transformers.
It may be my crazy head, or it could be the excellent example of “Strem-of-consciousness” writing above, or both, but I’m still confused what you are really trying to say. Are you or are you not saying one’s entire portfolio should be considered when making investment decisions?
Yes. You’re right, Bichon. I’m saying just be aware of *all* the different ways to diversify – and it’s not necessarily best to have each account it’s own little island. I could have said it better!
We don’t have the option for company stock. So what would you recommend for someone who doesn’t have that option?
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Well first, if your firm doesn’t offer company stock, then no Enron worries for you! From an investment standpoint, I would be looking at all your holdings – even those outside the 401k plan – from which to build your portfolio. If you have a Roth, the most aggressive things would go there. Things that generate interest income would go in tax-deferred accounts; if you’re in a lower tax bracket, stocks that pay dividends would go in your regular account. But, everyone’s different – my point here is that the common thought of “let me make a nice pie chart with each one of my accounts” leaves money on the table.
I might be completely wrong here, but I thought company stock was getting to be far less common in 401K offerings?
Since our company run 401Ks have fiduciary responsibility to the employees in it, isn’t it a conflict of interest to keep pushing company stock at them? I don’t think Mr. PoP can even buy shares of his company in his 401K, I think he’s limited to funds the same way I am (though my employer isn’t publicly traded).
Mrs. Pop @ Planting Our Pennies recently posted..He Said She Said: A Team of Professionals
It is becoming less common, you’re right. A lot of firms are now putting all their matching dollars in Co. Stock rather than letting you invest in it. Or at least they’re giving you the option to diversify out of it with no restrictions (read: Enron).
In re: fiduciary responsibility, yes, they have that, but they’re not violating that by offering co. stock. Firms would be wise, however, not to “push” it.
This is interesting and something that I have never come across before. My employer isn’t publicly traded, so I know that this doesn’t apply to me. I would definitely have to talk with someone about this if I was ever in the spot to work on this.
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Hmmm this is definitely something I should think about. We have an awesome stock purchase plan where you put 0-10% of your income each paycheck towards an ESPP account. At the end of the six months, they purchase the stock at the LOWER of the two prices at a 15% discount. Yes, your gains are technically unlimited and the “floor” of the gain is 15%. Now, I have been cashing this stock out every six months to avoid exposure of just having it in one stock. BUT if I don’t need the money I could leave some/all in there and use the NUA strategy…obvoiusly I’d have to consult a professional, but it’s a good thing to think about since I will be buying company stock every 6 months as part of the program as it is.
BTW this was a wonderful post. I hate when financial advisors spew the same lines over and over again about diversification and never take into account the client’s goals (or even just disregard goals such as your example in the beginning!)
DC @ Young Adult Money recently posted..Why Health Insurance Premiums Will Increase for Young Adults in the United States
DC -thanks for getting it.
an ESPP account you can’t do NUA with; only 401k plans. However, as you mentioned, the ESPP plan is a nice way to get “free” money. Keep in mind that selling the stock too quickly (memory says 2 years) will increase your tax bill: the 15% discount is then counted as ordinary income, vs. capital gains. could be a significant difference. Consider building a 2 year rolling position, then selling the shares that are 2 years old to limit risk.
Investing is personal! Your asset allocation should fit your objectives! Since I will have Social Security and a pension, I have my needs covered. I am very willing to take more risks with my portfolio. I want growth because I expect to live 30 years in retirement.
krantcents recently posted..Rich Man, Poor Man
Doing anything just because someone says you should or because others are doing it (especially if you are doing it the same exact way) is a great way to get into trouble. It’s the same as with diets–different people have different ways of processing food and one diet won’t work everyone no matter how great the results are. I think people are just too lazy to think for themselves in certain instances, although it shouldn’t come as much of a surprise these days!
Eric J. Nisall – DollarVersity recently posted..Identity Theft Prevention Just Takes A Little Effort
Eric – another guy who gets it. You rock.
I made that mistake of not being aggressive with tax free account. There was a choice of savings account or stock accounts and I chose a 4% savings account when my stocks and shares averaged much more that year. Lesson learned!
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I think we’ll part company on this one. Investing (and betting) wholly and exclusively on one’s own company’s stock is much like messing the bed.
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Right! I don’t know that it should be 100% or 0%; my point is that there are so many other factors to consider. Unless you’ve spent a *long* time studying all the different facets of tax law and investment strategy, the run-of-the-mill plan may not be the best! I’m just suggesting that there are ways to have your cake and eat it too. You just either have to a) invest the time and energy (Malcolm Gladwell says 10,000 hours) to learn it yourself, or b) reach out to a pro. That’s all.
I would leave a more stinging reply, but I have a feeling this post was written to stir the pot. And for that I say, “Great job!” because it worked on me.
Being agressive in your ROTH is a great idea if the client has the intestinal fortitude to ride out bear markets. Unfortunately, most folks do not possess that skill. And for those that will sell low and buy high, they should have a well diversified portfolio even in the Roth (as many look at their accounts separately, instead of looking at it as one whole “retirement savings”).
I would agree that the one size fits all advice that seems to float around the personal finance blogs is getting ridiculous. The attitude seems to be “it’s so easy a cave man can do it!” If it were so easy, then we wouldn’t be having the retirement crisis that is looming on the horizon.
Oliver @ Christian Money Blog recently posted..Financial Planner, Investment Manager, Financial Coach, or Broker?
I get frustrated too when I see advisors diversify the entire clients account as you mentioned in the post. If the investor wants an aggressive strategy, why invest in bonds in the IRA if they have a long time horizon?
One thing to keep in mind too is if you are investing in bonds, you are better off investing in government bonds in your taxable account and corporate bonds in your non-taxable account. The reason is because the income bonds throw off if taxed at ordinary income rates. With government bonds being mostly tax-free, you don’t get hit with taxes. With the corporate bonds, you can let those distributions grow tax-free.
Jon @ MoneySmartGuides recently posted..The More You Trade, The Less You Earn
Everyone should take time and do their research before they dive into these investments. Stocks are a big deal and shouldn’t be taken lightly at all! However, it is all personal so what might work for one might not work for the other.
While I wouldn’t advocate investing 100% of one’s 401k in the company’s stock, my takeaway from this is simply that there are many different ways to approach personal finance and potentially think differently than the herd. So while I won’t take on this specific approach, I think it’s quite interesting to learn. Good stuff!
Garbage in Garbage out – I would assume that the bank financial planner didn’t get a chance to see all the assets for a comprehensive plan (I base that assumption on fixing plans that they have done based on the main crux of your site).
Notwithstanding agreeing with the comprehensive view of asset allocation – I think being heavily weighted in any single stock especially the one that employs you is a risk that I couldn’t imagine taking for myself and thus recommending it would be dicey at best. Written a few years ago about an actual case:
http://www.myjourneytomillions.com/articles/for-most-investors-diversification-is-key/
She would have come partially back but what if she had worked for LEH.
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