Strength In Numbers: Wealth Retention Through Diversification




Lucas Hail, MBA, CFP®, Financial Planner & Shareholder

Photo by Jon Keeling

 

You may have heard the old saying, “There is strength in numbers.” This is typically used when talking about how it is physically safer to be with a group than to be on your own. The saying also can be applied to the safety of your financial situation.  In our practice we have seen great wealth created through investment in a single stock or privately-owned business. However, the same market forces that create wealth also reduce wealth. So, what’s the difference between a person that maintains the wealth once it has been earned and a person who doesn’t?

Our experience says a conscious decision to diversify concentrated stock positions and business interests is the largest factor in maintaining wealth and reducing risk. The process of diversifying allows the investor to take advantage of the strength gained through reinvestment in a variety of holdings.   

 

What Is Diversification and Why Is It important?

Diversification is the strategy of owning several investments with different risk and return characteristics as a way to mitigate risk and maintain wealth. Let’s take a look at a couple of examples of what diversification can do.

Procter & Gamble was founded in 1837 and has a great American history. During certain periods of time, P&G stock has created significant wealth for those that held its stock. In other time periods, the stock price has languished or fallen significantly and diminished the wealth of its stockholders. In July of 1989, the stock traded for $7 per share.  Fast forward 10 years to December of 1999, and the stock was trading at $56 per share. That is significant wealth creation! However, just a few months later in March of 2000 the stock traded at $28 per share. It lost about half its value in a few short months. That is significant wealth destruction!

More recently, after a long period of stagnant returns, the stock price rose from $72 per share in April of 2018 to a price of $115 per share in July of this year. These recent market movements have created significant wealth for those with concentrated positions in P&G stock. This is particularly good news for P&G’s employees with exposure through the P&G Profit Sharing Trust and P&G stock options with which we are familiar.

Always remember that the same market forces that create wealth can destroy wealth, too. Wealth creation is usually a very pleasant experience that includes dreams of a more comfortable life filled with time with family and travel. Wealth destruction is always painful, especially at the end of a working career.  It often requires revisions in the timing and standard of living in retirement. It can affect families for generations.

How do you make wealth creation permanent? Diversification: sell the single stock, exercise stock options or sell the closely held business and reinvest the proceeds in a collection of investments. The new collection of investments should include multiple smaller positions in stocks or stock mutual funds, bonds, cash and real estate. By choosing to diversify when a concentrated position has gained significant value, you are choosing to make your wealth durable and not fleeting.

 

An Emotional and Financial Decision

Choosing to diversify is often an emotional decision as much as a financial decision. It has been said that the stock market is ruled by two emotions – fear and greed.  A large part of being a successful investor is making rational decisions based on facts, not emotion. For the investor with a concentrated stock position considering making their wealth permanent through diversification, important tools include an accurate balance sheet, a detailed cash flow analysis and retirement projection. These tools can help to answer the question, “How much is enough?”

The answer to that question is different for each person, but it is typically a combination of needs and wants. Once that is established, an investor knows how much wealth is needed to fund their goals. At that point, the investor should sell enough of the concentrated position to create a diversified portfolio that should permanently fund their goals.

 

Timing Is Important

Although picking the right time to sell a concentrated position is important, trying to get the timing “perfect” can often be a psychological impediment to selling the position. We suggest switching perspective from “I need to sell at the highest stock price possible” to “I want to sell at a stock price sufficient to meet my goals.” Experience tells us that choosing the time to sell an entire stock position, even when it is related to “enough” to meet a person’s goals, can be another psychological challenge.

To overcome this challenge with an individual stock or stock options, you can sell the stock in meaningful but smaller amounts over a defined period of time. That could take the form of selling stock or exercising stock options every month, quarter or year. This is harder to overcome for a privately held business owner. Often, sale opportunities are rare and happen all at once. Knowing “How much is enough” is particularly important for a business owner. Often this single piece of information is the most important piece of information for a business owner in a business sale negotiation.

 

How Much Is Enough?

John D. Rockefeller once was asked how much money was enough.  His response was, “Just a little bit more.” Rockefeller’s response was a teaching moment as he intentionally illustrated the human weakness for greed. For the individual investor, those words offer insight into the human psyche and the proclivity to wait for the “perfect” stock price. The markets have been unusually strong for more than 10 years. If you have accumulated wealth in an individual stock or business, now is a great time to make your wealth permanent through diversification.

To determine “How much is enough?”, develop a partnership with a Certified Financial Planner (CFP®) that practices as a Fiduciary.  A Chartered Financial Analyst (CFA®) can help you build an investment portfolio that meets your goals while keeping in mind your concentrated stock. That is why, at Foster & Motley, clients have both a financial planner and an investment manager to create a cohesive, comprehensive wealth management experience. Together with your CFP® and CFA® professionals, you can build a plan to make your wealth more secure. Timing matters. Don’t let this opportunity to secure your future pass you by.

Foster & Motley is located at 7755 Montgomery Road, #100, Cincinnati, OH 45236. For more information, visit www.fosterandmotley.com.