We’ve all met him – the Reluctant Diversifier.
Despite the evidence that diversification is the single best way to protect and grow wealth over the long term, this investor continues to resist his adviser’s recommendation to diversify.
Why? The Reluctant Diversifier may have an emotional connection to the stock, a belief the stock’s prospects are superior to any alternative, or a desire to avoid a hefty capital gains tax.
It’s easy to imagine a Reluctant Diversifier today. Companies like Amazon, Netflix, Google and Apple have provided eye-popping returns over the past decade. Who needs diversification when just a few deliver quadruple-digit gains?
Twenty years ago, General Electric was the stock market darling, and likely counted many Reluctant Diversifiers amongst its shareholders. GE had paid a handsome quarterly dividend to shareholders for nearly 100 years, had increased those dividends for 34 consecutive years and had outperformed the S&P 500 Index by 17% per year for five years. It was the most valuable company on the globe.
Since then, however, General Electric has suffered a series of humbling setbacks. The company recently reported massive losses, is at the center of a U.S. Securities and Exchange Commission investigation into its accounting practices and has cut its dividend in half.
This venerable giant’s slumping silhouette provides a poignant lesson about diversification.
To illustrate this lesson, let’s consider the case of two long-time GE shareholders and friends, Karen and Robert. Karen diversifies; Robert doesn’t. Over the course of 20 years, their mutual adviser’s recommendation is the same, but the decisions they make will result in very different outcomes.
The Difficult Decision
There are countless reasons why Karen and Robert could voice opposition to selling their appreciated GE shares. A common one is the hefty capital gains tax owed on selling highly-appreciated shares. Robert’s reluctance to pay the tax bill causes him to ignore his adviser’s recommendation. Karen, however, heeds the recommendation.
Karen sells her $1,000,000 position in GE in July 1997. Assuming she’d bought GE stock two years earlier, she would have been responsible for roughly $250,000 in capital gains taxes, considering both the long-term federal and Oregon capital gains tax rates at the time. Of the $1,000,000, therefore, only $750,000 would have been available for reinvestment in a diversified stock portfolio.
Karen and her adviser agree to meet every year to review her diversified portfolio, consisting of 40% U.S. large value stocks, 20% U.S. small cap stocks, 20% developed international stocks, and 10% each in emerging market stocks and U.S. real estate investment trusts (REITs).
As time goes on and she compares the results of her new portfolio to the shares of GE she once held, she becomes increasingly agitated.
After one year, Robert is beaming when he tells Karen, “My $1,000,000 in GE shares has grown to $1,359,582!”
Karen’s diversified portfolio? After accounting for the $250,000 paid in taxes, it is worth just $837,300.
“Stay disciplined,” her adviser encourages.
A Growing Gap
The following year, the gap between Karen’s and Robert’s portfolios is even greater.
“My portfolio is now worth $1,678,000!” Robert proudly tells Karen.
Karen’s diversified portfolio is worth only $928,984.
Another year later, that gap is even wider. The blue-chip GE stock Robert owns is now worth $2,264,808 while Karen’s diversified portfolio has grown to just $973,575.
Karen, filled with anxiety and regret, goes back to her adviser. “I never should have sold! Are you sure I shouldn’t liquidate my diversified portfolio and re-purchase shares of GE?”
“Be patient and focus on the long term,” says the adviser. Karen begrudgingly agrees.
Patience Pays Off
Fast forward to today, and how does Karen’s portfolio look?
Despite enduring the dot-com crash, a “lost decade” for U.S. stocks and the worst financial crisis since the Great Depression, her diversified stock portfolio performed quite well. After accounting for the initial taxes owed on the sale of GE shares back in 2000, her $750,000 diversified portfolio has grown to over $3.5 million.
What about Robert, who never diversified in the first place? His $1,000,000 invested in General Electric shares would be worth $1,436,760. That’s roughly $2,000,000 less than the value of Karen’s diversified portfolio, even after accounting for the $250,000 initial tax bill she paid to diversify.
Don’t Be a Reluctant Diversifier
To be fair, while Karen’s diversified portfolio beat Robert’s concentrated GE shares in this example, the same result can’t be guaranteed for different stocks over different time periods.
History is filled, however, with examples of once-dominant firms that eventually struggled in the face of changing consumer preferences, technology or competition. Bethlehem Steel, Polaroid, Sears and Kodak are just a few. The technology boom and bust of the early 2000s (WorldCom, Enron, America Online) and the more-recent Global Financial Crisis (Bear Stearns, Lehman Bros, and Washington Mutual) are vivid reminders of the risk of putting too many eggs in one basket.
It’s also filled with Reluctant Diversifiers: investors with an emotional connection to a stock, a belief that their stocks’ prospects are superior to any other, or a desire to avoid a hefty capital gains tax.
Karen and Robert’s story can be viewed as a cautionary tale for those investors who are reluctant to diversify a concentrated, highly appreciated stock position in any company, even today’s high fliers.
Investors should focus not on yesterday’s returns or today’s tax liability, but rather the best way to grow after-tax wealth over the long term.