Different Baskets: How Diversification Helps You Grow Wealth

Three wicker baskets filled with brown eggs are arranged on a wooden surface, alongside a rolled-up paper and scattered coins.

It’s not an uncommon scenario for a young professional: you go to work for a company that is growing rapidly – maybe a high-tech startup or some other enterprise that is expanding aggressively into a well-defined business niche. The company does well, and the profits start rolling in. Before too long, you receive a generous equity compensation package – perhaps stock options or actual shares. As the company continues to prosper, the value of your package continues to increase. It’s more money than you’ve ever had in your life – and it’s all concentrated in a single type of asset that is 100% dependent on the continued prosperity of your company.

Here’s another example. Your wealthy uncle passes away, and in his will, he leaves you a few thousand shares of a blue-chip stock like Exxon or Walmart. Once again, you’ve got an asset with significant value, but that value is controlled by the destiny of a single company.

This type of holding is what is called a “concentrated position”: all of your wealth is tied up in a single entity. Sure, having all that value is a nice feeling, but is it a good idea?

While it is somewhat natural for a person in either of these positions to want to hang onto the asset, it may not be the best strategy for maintaining and growing long-term wealth. Sure, you feel loyalty toward the company, but what happens if the fortunes of the company take a downturn? Ask former employees or major shareholders of Theranos or Enron what happens when your investible assets consist of stock in a company that is headed for bankruptcy.

The answer to this dilemma is diversification: placing your investment “eggs” into different baskets. By spreading your investible funds among different asset classes – like a mix of equities (stocks), fixed income (bonds), and cash – you reduce the likelihood that the value of your investments will take a serious hit because of negative events at a single company. Diversification doesn’t eliminate risk, but it is perhaps the best tool investors have for managing the risks that are an inevitable part of investing in the financial markets.

It’s important to know that there can be costs associated with “unwinding” a concentrated position. For example, if your company stock has increased in value while you’ve had it – a good result – you will probably owe capital gains taxes when you sell it. This means that unwinding a concentrated position may take time and careful tax planning in order to minimize the bite that the government takes from your portfolio. An advisor at Griffin Black can help you understand the risk of not diversifying as well as the tax impact of various diversification strategies. Although paying taxes can be painful, they should not be the primary driver when considering a diversification strategy. The goal is to reduce your exposure to the single stock and move funds into a diversified portfolio that is aligned with your risk tolerance and financial goals.

To learn more about how we can help young investors form solid financial habits, visit our website.

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