When it comes to managing your resources, should you concentrate your assets in a principal holding, or diversify your investments across multiple asset classes, managers, geographies, etc.? This decision is particularly challenging if you own, or are the trustee of, a concentrated long-held (i.e., legacy) asset and are concerned about your exposure to risk. Please see my brief video about a private foundation’s decision to concentrate vs. diversify their holdings.
On the one hand, some advisers recommend that you concentrate your holdings and watch them like a hawk. On the other hand, some advisers think that having all your eggs in one basket is too risky, and recommend that you build a diversified portfolio instead. Arguably, both advisers are right. Wealth is usually created through concentrated holdings and vigorous risk-taking; while wealth is usually retained through risk-managed diversification.
If you are wondering whether you should retain a concentrated legacy holding or diversify your portfolio, here are five key factors that may drive your decision about diversifying a concentrated legacy holding:
Five Key Factors for Diversifying a Concentrated Legacy Holding
- Quantitative Analysis
In the private foundation video clip referenced above I addressed the question, “How much diversification is enough?" You might ask, "Enough for what?" The answer is, "Enough for you to sleep at night!" In that example, the legacy holding was a blue chip company and the asset owners and trustees were concerned about the volatility of the company's stock, the public profile of their foundation, and their desire to make long-term, multi-year grant commitments. After analyzing these considerations we were comfortable with retaining a significant portion of the concentrated legacy holding and diversifying a piece of it.
- Recommendation: The sort of quantitative analysis employed is too refined to discuss in detail here. Suffice it to say that quantitative analysis can play a key role in your decision process. You should work with a qualified professional in conducting quantitative analyses.
- After Tax Investment Returns
If you liquidate a concentrated legacy asset to build a diversified portfolio (also known as an endowment model portfolio), you will have to cash-out your 'silent partner,' Uncle Sam by paying a capital gains tax. Depending upon your cost basis and how long you have held the asset, you might have a substantial tax liability when you sell it. This means that you will have fewer dollars to invest in your newly diversified portfolio.
- Recommendation: If it makes sense for you to sell your concentrated legacy asset, then be sure that your new investments can earn enough money to recoup the taxes that you paid in a time frame that is suitable in your circumstances.
- Tax Trends
There is a good chance that the Bush-era tax cuts will expire at year-end and capital gains taxes will increase. Of course, the political process could intervene to avoid such a tax increase.
- Recommendation: If you think that the capital gains tax will increase at year-end 2012, then this might not be a good time to sell a low tax-cost-basis concentrated holding.
- Knowledgeable Risk Assessment
The original wealth creator usually has the capacity and knowledge to make informed decisions about their concentrated legacy holding. Unfortunately, subsequent generations do not always have the capacity, opportunity or inclination to develop an understanding about the future of their concentrated legacy holding(s). As a result, the legacy asset often becomes a sort of faith-based asset that is held in an almost complete vacuum of critical thinking. One former client remarked, “When a family no longer controls the day-to-day management of their principal asset, when they no longer know more about that asset than anyone else on Earth, then it is time to declare victory and to get off the train – call it Station Success -- and to diversify their portfolio.”
- Recommendation: Develop and maintain a profoundly knowledgeable and deeply informed understanding about your concentrated legacy holding and have a crystal clear vision of its future outlook. If you are not in a position to do that, then give serious consideration to diversification.
- Evolving Personal Priorities and Needs
A wealth creator in her/his prime of life may be thrilled to embrace the risk and volatility of a massively concentrated investment. However, priorities and needs may change over time and certainly across generations. An inheritor’s needs and priorities, or those of the wealth creator’s charitable beneficiaries, may be significantly different than those of the wealth creator’s.
- Recommendation: Have a candid and fully articulated conversation with your advisors, and if possible your family members and/or fiduciaries-to-be, about your evolving priorities and needs as they relate to your investment philosophy and diversification plan.
As you mull over the five (5) key factors that I have addressed here, it would be wise to address them in a thoughtful dialogue with your investment advisory team. Your feedback on this article is valuable to me. Please share your thoughts by dropping me a note or giving me a ring at 617.945.5157. You can also rank this article, share it with a friend or leave comment below.