When Diluting Your Holdings Makes Sense
Wednesday, February 06, 2013
The old saying about not putting all your eggs in one basket can still be good advice, especially when it comes to investing.
Yet, too many investors may be doing just that. Whether itï¿½s a cache of employer stock or shares of a favorite company with a dividend reinvestment plan, holding too much of one investment exposes investors to significant risks.
The solution to reducing those risks is to break up those concentrated holdings and build a well-diversified portfolio.
"By diversifying, investors spread their exposure across multiple investment choices and protect themselves from the effects of the market on one company," says Tracy Green, CFP', vice president, Financial Services Group at Wells Fargo Advisors.
Such a strategy is not only likely to reduce investment risk; it may also provide for a potentially greater return than a single-stock position by benefitting from growth in different areas of the market.
Spreading the Wealth
Wha's wrong with holding only a handful of securities or one asset class? Quite simply, your portfolio is much more vulnerable to losses if those investments don't perform well.
"This year a particular security or asset class may be a top performer, but next year there may be some news that depresses those prices–and in turn, significantly lowers your portfolio's value,"Green says.
How much is too much when it comes to one holding will vary from investor to investor?
Green notes that your investment objective and risk tolerance –he potential for losses or gains you can comfortably handle in relation to your goals – will play a key role in determining how much is too much of one holding.
"Some people are comfortable holding a disproportionate share of their portfolio in a single stock. In 2006, Congress posed (through the Pension Protection Act) that if an investor had more than 20 percent of a portfolio in one security or industry, the portfolio may not be properly diversified, but an asset allocation model may indicate a much lower percentage is too high," she says.
The goal is to reduce your risk by filling an asset class with more than one security.
If you find yourself with a portfolio that is too heavily concentrated in one investment or sector of the market, the next step is to unwind those positions. Several strategies can help you work yourself out of a position, such as gradually selling and repositioning the assets, using hedging strategies or donating a portion of those holdings to charity.
The right strategy depends on your specific situation. To determine how best to reduce a concentrated holding, talk about the end result you'd like with your Financial Advisor, who can review your overall plan and help you identify strategies that suit your circumstances.
"There's a lot to consider before rebalancing your portfolio," says Green.
For example, do you want to continue to hold any portion of the position, or would you prefer to liquidate it completely? Are you restricted from selling certain blocks of your company stock?
Tax considerations also play a role: If a concentrated position is held in a tax-deferred account such as a 401(k), there should be no tax consequence for unwinding it– but you also need to weigh the potential benefit of instead distributing the employer stock out of your plan and into a taxable account to provide some long-term tax savings.
However, if the asset is held in a taxable account, you might incur considerable capital gains. It's always smart to bring your tax professional into conversations about investing decisions that could have tax implications, and this is a prime example of such a time.
Most often, individuals unwind a concentrated position over time, to spread their sales across market conditions and thereby avoid cashing out at a relatively low price. That said, there are benefits to not waiting.
For starters, the long-term capital gains rate "currently set at a maximum 15 percent" is scheduled to rise in 2013, so selling off a portion of your portfolio at that point could trigger a larger tax bill. And of course, during that time the fragile market recovery that's under way could endure quite a bit of volatility.
Dealing with lopsided investments quickly and with the guidance of your Financial Advisor can also help you develop a strategy to avoid such an unbalanced portfolio in the future.
"The most important thing is to develop a plan now and monitor it closely," Green says.
This article was written by Wells Fargo Advisors and provided courtesy of Terry R. Campbell, Senior Vice President - Investments in Chardon at 440-286-2553.
Investments in securities and insurance products are: NOT FDIC-INSURED / NOT BANK-GUARANTEED / MAY LOSE VALUE
Wells Fargo Advisors, LLC, Member SIPC, is a registered broker-dealer and a separate non-bank affiliate of Wells Fargo & Company.