Thursday Oct 21, 2021

How Much You Lose by Not Diversifying Your Investments

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How Much You Lose by Not Diversifying Your Investments

Information about How Much You Lose by Not Diversifying Your Investments

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Editor’s Note: This story originally appeared on SmartAsset.com.

Whether you’ve inherited stock, received equity in your company or simply own only a few holdings, a highly-concentrated portfolio may cause you to miss out on significant wealth by not diversifying.

Recent research from Dimensional Fund Advisors (DFA) shows that liquidating a concentrated portfolio with relatively few holdings and transitioning to a diversified set of investments would produce more wealth in the long run, despite initially generating a tax bill.

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DFA study findings

Using a hypothetical investor with a five-stock portfolio worth $1.5 million, DFA determined the portfolio would be worth nearly twice as much after 25 years if the investor transitioned to a more diversified set of holdings with higher expected returns.

“Incurring capital gains tax is a tangible cost investors face in transitioning to a well diversified portfolio,” DFA researcher and vice president Kaitlin Simpson Hendrix wrote in a 13-page report titled “SMAs: Quantifying the Tradeoffs Between Taxes and Diversification.”

Of course, there can be that sizable tax hit upfront. Yet, she continued, “the less tangible costs of not transitioning, in terms of what an investor may be giving up in the future, may be greater.”

Concentration versus diversification

Just how much is an investor forgoing by not transitioning to a broadly diversified portfolio with more holdings? To answer this question, DFA compared the 25-year outlook of a concentrated $1.5 million portfolio with a pair of hypothetical alternatives.

In both alternative scenarios, the investor would liquidate an existing portfolio, pay taxes on the capital gains and then reallocate the assets to a more diverse array of holdings.

The first alternative portfolio, referred to as Transition A, maintains the same expected rate of return as the existing portfolio (9%) but has more holdings. The second alternative, dubbed Transition B, focuses on stocks with higher expected returns (10%).

Assuming a capital gains tax rate of 25%, both alternatives would generate a tax bill of approximately $125,000, leaving the investor with a cost basis of $1.375 million.

However, both benefit from lower volatility compared with the five-stock portfolio, which dramatically improves their compound returns over time.

As a result, the alternative portfolios produce millions of dollars more than the highly concentrated portfolio, according to DFA.

Here’s a look at the investor’s existing portfolio and its 25-year outlook:

  • Initial portfolio value: $1,500,000
  • Cost basis: $1,000,000
  • Tax rate: 25%
  • Expected return: 9%
  • Volatility: 30%
  • Total wealth in 25 years (after-tax, post liquidation): $4,144,189

Here’s a look at Transition A and its 25-year outlook:

  • Initial portfolio value: $1,500,000
  • Cost basis: $1,375,000
  • Tax rate: 25%
  • Expected return: 9%
  • Volatility: 20%
  • Total wealth in 25 years (after-tax, post liquidation): $6,222,259

Here’s a look at Transition B and its 25-year outlook:

  • Initial portfolio value: $1,500,000
  • Cost basis: $1,375,000
  • Tax rate: 25%
  • Expected return: 10%
  • Volatility: 20%
  • Total wealth in 25 years (after-tax, post liquidation): $7,784,609

While the existing portfolio would be worth $4.1 million by the 25-year mark, the investor would forgo $2.1 million in potential growth by not opting for Transition A.

The opportunity cost would be even greater compared with Transition B, which would be worth $7.7 million in 25 years.

“Diversification is an integral part of robust portfolio design and increases the probability of capturing the premiums and outperforming the market,” Hendrix wrote. “However, there is no reliable way to predict which securities will deliver the premium in a given period. Therefore, concentrated investment solutions may miss out on the very stocks that deliver the premiums.”

Bottom line

The DFA research points to a variety of benefits associated with diversified portfolios, including lower volatility and increased probability of capturing premium returns.

An investor with a $1.5 million portfolio that comprises just five stocks would stand to make an extra $2.1 million over the course of 25 years by transitioning to a diversified portfolio with similar returns.

Meanwhile, transitioning to a diversified portfolio that seeks even moderately higher returns over 25 years would leave the investor with $3.6 million more compared with the concentrated allocations.

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