Concentrated Wealth – It’s More Common Than You Might Think

Diversification is one of the foundations of conventional financial planning. While a diversified portfolio generally reduces risk and volatility, it can also lower your potential capital gains. What happens if we set aside for the moment the notion of diversification and think about concentrated wealth instead? Business owners and real estate moguls commonly come to mind when considering investors with concentrated wealth. However, many of us often have a concentrated wealth position without recognizing it. Let’s take a deeper dive into the subject of concentrated wealth, how it occurs, the pros and cons, and tips for deconcentrating your wealth, if appropriate.

How to Define Concentrated Wealth

Do you own a house? Are you an entrepreneur or a small business owner? Have you participated in stock option or stock grant plans in your company?

You likely have concentrated wealth if you answered yes to any of these questions. Let’s do the math. To calculate whether an asset can be considered a concentrated investment, figure out your net worth (the total of all your assets minus your liabilities) and then divide it by the amount you have in what might be a concentrated investment. If you own something or have a position in an asset that makes up more than 10% of your net worth – you have concentrated wealth. Some of the most common types of concentrated wealth include:

• Real Estate: A property you own free and clear or have taken out a mortgage, but your ownership amount is still larger than 10% of your total net worth.
• Business Related: You own (either entirely or partially) a business or receive non-cash payments representing ownership in a company (ownership shares, restricted stock options).
• Personal Investments: An individual stock or fund (or interest in a private company or venture) that either started as or has grown over time to represent more than 10% of your net worth.

Building Wealth vs Preserving Wealth

Building wealth involves actively increasing one’s assets through endeavors such as growing a business, investing in stocks, or accumulating equity in property. It’s a proactive approach focused on generating substantial returns over time. On the other hand, preserving wealth entails safeguarding existing assets by minimizing risks and diversifying investments. This strategy prioritizes stability and protection against market volatility, aiming to maintain and grow wealth steadily while mitigating potential losses. While both approaches are crucial in financial planning, they operate on distinct principles, with wealth-building emphasizing growth and preservation emphasizing stability.

When individuals are successful in their wealth building, over time, they often find themselves in concentrated wealth positions. While the upside of their success has gotten them to where they are in life, as life’s time horizons shift, so should the risk. Preserving wealth often means doing the opposite of what it took to create it. Generally, this requires a shift to a lower overall level of risk by diversifying or deconcentrating their investments and moving from active involvement in wealth creation (like owning a business or real estate) to a passive role (investing in other assets). If we think in terms of two buckets, the money in the creating wealth bucket can generate significant returns or go to zero. Money in the preservation bucket grows wealth less spectacularly but reliably over the long term. As the value of the creating wealth bucket grows, moving assets to the preserving one may make sense^.1

Using Diversification as a Tool

There are many considerations when considering a move to deconcentrate assets. While a diversified portfolio may lower the overall risk level, it can also reduce potential gains. One of the potential benefits of a more concentrated portfolio is that while it increases risk, it also increases potential gains. Investment portfolios that obtain the highest returns for investors are usually less widely diversified.² The more extensively diversified an investment portfolio, the more likely it is to mirror the overall market’s performance. The smaller a position in a portfolio, the less impact it will make if it moves up or down in value. Conversely, a portfolio will be more sensitive to a larger position.

Another aspect to consider when looking at concentrated wealth is the liquidity of the investment. A business and real estate, often a primary residence, are less liquid assets. They are generally harder to sell and could put the investor at a disadvantage if a quick sale is required. Tax consequences also play a role when considering the move to diversify. A concentrated position may have a significant tax consequence, leading an investor to hold the position longer than they desire.

Investors should consider diversification’s relative advantages and disadvantages within a personalized framework. Some questions to ask yourself:

• Does my portfolio align with my risk tolerance and time horizon?
• Do I have tax losses that can offset gains to allow me to implement a tax loss harvesting strategy?
• Can I donate part of my concentrated position to a DAF so that the charity can benefit from the asset’s value without paying taxes?
• Is it time to begin to shift assets into other asset classes?

Investors should consider diversification’s relative advantages and disadvantages within a personalized framework. The primary focus of an investment portfolio should always be meeting the individual’s personal goals and financial needs.

Navigating the intricacies of managing your concentrated wealth requires careful consideration of liquidity, tax implications, and long-term By aligning investment strategies with individual circumstances and goals, investors can strive to preserve and grow their wealth prudently over time. At Treehouse Wealth, we’re here to help you evaluate your financial situation and craft a well-thought deconcentrating strategy if needed. Watch our webinar on Concentrated Wealth, or contact us for more information on how we can help.