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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