Let me introduce you to my client, Grant (not his real name, of course). He originally came to us for help because the startup tech company he had been with for several years did an IPO, and Grant found himself with stock and stock options worth something north of $150 per share.
Not long after we began working together, the Fed embarked upon a cycle of interest-rate hikes designed to rein in the inflation that was threatening to take off for the stratosphere at the time. Like many other growth companies, Grant’s took a major hit to its stock price; he saw his holdings go from nearly $200 per share at their peak to as low as $35 per share.
The company appears to be weathering the storm, and Grant feels good about the future. However, we are now working with him to achieve better diversification. This will reduce the impact of market fluctuations on his net worth from his equity compensation package.
Capital-gains Conundrum
Now meet Claudia (also not her real name). Claudia began accumulating positions in chipmaker Nvidia a few years ago, when the whole AI furor was hardly more than a cloud on the horizon. She really believed in the company, though, and steadily added to her position over the months. At this point, she has paper gains of something like 2,000%. Clearly, it would be a good idea to take some profits and diversify into other areas, but now Claudia has a sizeable capital gains situation to consider.
Claudia understands that she is severely overweighted in Nvidia, but she still believes in the company and isn’t eager to take the tax hit necessary to unwind the position. We are counseling her to not let the taxation “tail” wag the long-term strategy “dog,” but she is understandably hesitant to take action.
At one time or another, most of us have probably quoted the famous proverb to our clients about diversification: “Don’t put all your eggs in one basket.” But it’s possible that occasionally a client who has built significant wealth by means of spectacular success in a particular area might reply with the inverse: “Put all your eggs in one basket and watch that basket very closely.”
While it’s certainly true that diversification is a cornerstone of any long-term wealth preservation strategy, we need to remember at the same time that many of our clients who have built significant wealth did it by creating concentrated wealth. And we also need to remember that concentrated wealth involves more than those who become “IPO millionaires” or those with large equity compensation packages; in fact, it is likely that the most frequent occurrence of concentrated wealth is among small business owners.
Studies have shown that it is not uncommon for small business owners to have as much as 40% of their net worth tied up in the business. Similarly, many of our clients live in homes that are either paid for or that have equity significantly greater than the indebtedness on the home. This, too, can be a source of concentrated wealth, depending on what percentage of the client’s net worth is represented by this single asset.
Not a One-Size-Fits-All Solution
But approaching the discussion of concentrated wealth—and, more importantly, what, if anything, to do about it—depends heavily on the client’s circumstances, stage in life, position on the wealth creation/wealth retention continuum, and other factors. For some clients, it may be essential, as part of a retirement funding strategy, to “unwind” concentrated positions so that the assets can be allocated for providing long-term income and growth. For others, the concentrated position may be integral to current wealth-building strategies. This article will consider both phases of the cycle and offer suggestions for working in synergy with clients’ needs and goals.
To Build or to Preserve?
Clients in the wealth-building phase are actively pursuing endeavors intended to produce wealth: growing a business, accumulating equity as a company executive, building a real estate portfolio, or investing in other enterprises expected to generate a substantial return. Those in this phase typically narrowly focus their efforts and may devote a substantial amount of personal assets to these pursuits. They may also use debt to leverage the potential returns.
Put simply, many in this phase are taking an “all the eggs in one basket” approach, expecting that the success of the venture will generate the type of significant returns upon which fortunes are built. By taking calculated risks — “watching the basket carefully” — they aim to reap the greater rewards that can accompany bigger risks.
Helping the ‘Builders’ …
Financial advisors to individuals who are in the building phase can often serve best by helping the client manage risk, to the extent possible. They may wish to help the client attend to various forms of insurance — life, health, property, liability and others — to mitigate some portion of the uncertainties that inevitably accompany the wealth-building phase.
Financial advisors may also wish to encourage the client to begin planning for the longer term (the preservation phase) by establishing tax-advantaged accounts for retirement, healthcare and education (depending on their circumstances). It is also vital for wealth-builders to have sound estate-planning and legal structures in place as a way to insulate their personal assets and their families as much as possible from the financial risks that accompany this phase.
… and the ‘Accumulators’
Over time, those who are successful in the building phase will need to turn their focus toward preserving the wealth they have accumulated. They may possibly even wish to consider strategies for founding and perpetuating a multi-generational financial legacy. When they reach this stage, it is important for the advisor to communicate the importance of refocusing strategy: moving the eggs into different baskets.
While preservation strategies may still be targeting additional growth, it is likely to be of a different and more gradual nature than that achieved during the more volatile wealth building stage. It may help the client to think of two “buckets”: a “creation bucket” that could demonstrate spectacular growth, could go to zero, or something in between; and a “preservation bucket” that would be intended to grow more dependably, though more slowly, over time.
Diversification as a Preservation Tool
As we counsel clients moving from one phase to another, it’s important to ensure that they understand the differences between wealth building strategies and wealth preservation strategies. On the one hand, the concentrated positions—with a small business, real estate holdings, stock options, or other types of assets that typify various wealth-building endeavors—can generate dramatic gains in a relatively short period.
On the other hand, the value of the assets can fall just as quickly. Concentrated wealth can expose its owner to extreme volatility (the higher risk/reward ratio mentioned earlier). Diversification, on the other hand, is intended to reduce volatility. We should remind clients that, while there is always risk present in any portfolio, diversification is intended to reduce volatility by spreading risk across a variety of asset classes. While the potential for growth is still present, it is likely to be more gradual.
Questions to Ask
For clients at both ends of the wealth building/wealth preservation continuum, advisors should be posing some questions to help them evaluate and assess the relative advantages and disadvantages of maintaining a concentrated wealth position or pursuing diversification. These questions include:
Does the client’s portfolio align with their current risk tolerance and time horizon? (Note that the answer to this question will likely be a “moving target” over time and as the client’s circumstances change.
Does the client have tax losses that can offset gains to allow them to implement a tax loss harvesting strategy?
Can the client donate part of their concentrated position to a donor-advised fund so that the charity can benefit from the asset’s value without paying taxes? (This can be especially effective with illiquid assets such as real estate and business interests)
Is it time for the client to begin to shift assets into other asset classes?
Note that for clients with high concentrations in illiquid areas, this last question will likely also surface taxation considerations that should be carefully discussed with a tax advisor and possibly a legal expert. Considerations around selling a small business may also impinge upon the client’s estate planning, especially if the client intends for a child to take over management and/or ownership of the business.
Julie Meissner is a founding partner and CEO of Treehouse Wealth Advisors, where she leads strategic growth, client engagement and advisor development. She focuses on helping both clients and employees on their path to create and live a meaningful life. Julie created Treehouse Wealth Advisors to empower clients to invest their time and assets purposefully and to empower employees to inspire one another to reach their full potential. Julie received her CRCP designation through the FINRA Institute at Wharton.
