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The Pros and Cons of the Highly Concentrated Position

Summary

Many people have an overabundance of wealth tied up in what’s commonly called a “highly concentrated position.” This is basically an asset on your balance sheet that represents a large portion of your net worth.

Some common examples of a highly concentrated position include: A personal residence that you own free and clear, a business that you own outright or are in partnerships with others, an individual stock or mutual fund that has grown large enough to represent more than 10% of your investment portfolio, or stock options in a single company.

Whatever type of highly concentrated position you may have, these can be both a blessing and a curse.

In this episode of the Science of Economic Freedom, “The Pros and Cons of the Highly Concentrated Position,” we discuss the advantages and disadvantages of these situations. And, we do it through the lens of helping you achieving and sustain economic freedom.

Topics covered in this episode include:

  • The long-term risks of a highly concentrated position
  • Being “house rich and cash poor”
  • Business ownership, partnerships and how to plan for the future
  • The need to avoid selling at a deep discount
  • The tax advantages and disadvantages of the highly concentrated position
  • How to assess your personal balance sheet and identify highly concentrated positions
  • Plus, much more…

Transcript:

Doug: Do you have an asset that represents a large percentage of your net worth? What special risks and benefits do highly concentrated positions pose? And if you own stocks, bonds, real estate, or private business interests, this episode of The Science of Economic Freedom will be of benefit to you.

Announcer: The Science of Economic Freedom is intended as an investor education resource. The views and opinions expressed on this program should not be construed as a recommendation to buy, sell, or hold any specific security. Consult your investment advisor and read any investment perspectives carefully before making any changes to your investment portfolio.

This program is sponsored by Mercer Advisors. Mercer Global Advisors Inc is registered with the Securities and Exchange Commission and delivers all investment-related services. Mercer Advisors Inc is the parent company of Mercer Global Advisors Inc and is not involved with investment services.

 

Intro

Doug: Welcome to The Science of Economic Freedom. I’m your host, Doug Fabian. This podcast is about helping you achieve your financial dreams – we call that economic freedom.

This program is about your journey to achieve economic freedom for yourself and your loved ones. Today, we want to help you identify your next step on that journey.

This is Episode 29, Understanding the Highly Concentrated Position on Your Balance Sheet. Now, what is a highly concentrated position? This could be a position in real estate, equities, fixed income, or ownership in a business.

The purpose of this discussion is to give you an overview. In future episodes, we will discuss each specific asset class and drill down into more details.

But before we get into today’s topic, a few reminders about what’s going on at The Science of Economic Freedom. If you are new to the podcast and the website, welcome. The best way to get started, if you’re just beginning your journey to economic freedom, is to review the first 11 episodes of the podcast. This is our foundational material and will give you the knowledge and background to move forward.

Please review the special reports in the Resources section of the website, how to build your balance sheet, how to create a spending plan, seven ways to give yourself a raise, tax law essentials, and our special report on goal-setting. All of these reports are designed to get you moving toward your destination, economic freedom.

Now, we want your feedback. If there’s a subject you want us to cover on the podcast or you have questions, please send us an email. The email address is [email protected].

 

What is a highly concentrated position on a balance sheet?

Now, let’s get to the subject at hand, the highly concentrated position. What is a highly concentrated position? It is an asset on your balance sheet that represents a large portion of your net worth.

Here are some examples of highly concentrated positions:

  • A large concentration of your net work in real estate
  • A business that you own outright or are in partnerships with others that is a meaningful portion of your net worth
  • An individual stock, a group of stocks or a mutual fund that has grown large enough to represent more than 20% of your investment portfolio
  • Stock options or ownership you have earned
  • A concentrated position in a few securities that represents a single asset class—that could be bonds or trust deeds or oil stocks

We have categorized concentrated positions into four asset classes: equities, fixed income, real estate, and business ownership. As we mentioned in our introduction today, this episode is an overview on all concentrated positions. We will be doing separate episodes on each asset class since there are different issues that should be addressed for each.

 

A blessing and a curse

But here is the big issue. The concentrated position can be both a blessing and a curse. The blessing comes from the fact that concentrated positions can build extraordinary wealth. There are no current taxes on the increase in value, and there is no limit to how high an asset can go up in value.

But there are also risks. Sometimes, you can’t sell when you want to or you need to. Market conditions can change. Assets can fall in value considerably, even all the way to zero. Therefore, concentrated positions need attention, forethought, management, and planning.

 

Get a balance sheet

Now, here is an assignment for you. If you have not done so already, please review Episode 5 of the podcast on balance sheet basics and complete the balance sheet exercise in our special report in the resource section of the website.

Your balance sheet is so important to your long-term goals. This document should be updated annually. It is a list of your life’s work, the assets you have accumulated. Super important. Your balance sheet lists your assets, your liabilities, and this is where you can easily spot a highly concentrated position.

 

Economic freedom

Now, let’s discuss economic freedom once again. Economic freedom is financial independence as you define it for your family. Once you have achieved it, you should not have to worry about money. You have consistent cash flow from your assets to sustain your lifestyle.

A concentrated position can pose risks to that lifestyle. If so, then that highly concentrated position should be managed so you do not jeopardize the economic freedom that you have achieved.

 

Risky highly concentrated positions on your balance sheet

  1. You could have a highly concentrated position in a personal residents, where you are house rich and cash poor. In this situation, you may not want to sell to unlock the equity, but you need more cash flow to support your lifestyle.
  2. A highly concentrated position in a business. Let’s say you’re married. Can your spouse operate the business if something happened to you? Would the business need to be sold at a deep discount if you were not there? Do you have a partnership? Would the partner buy out your spouse?
  3. You have a substantial amount of assets in real estate, and all of a sudden you need liquidity, and the housing market is in a downtrend. Do you sell at a deep discount?
  4. You own a large block of bonds, and there is credit risk—an example would be General Motors—that could cause the value of the bonds to fall. 8% General Motors bonds became worthless in 2008 when the company went bankrupt. The same thing happened to Lehman Brothers.
  5. A large position in equities with a low-cost basis can also bring stress if declines substantially hit your net worth.

All of these are real-life situations that people have because they have highly concentrated positions, and they have not thought through what the future lays out for them.

 

Risks of highly concentrated positions

  1. There is liquidity risk. Liquidity is how easy and fast you can sell an asset. If it is an individual stock that is publicly traded, it’s easy to sell. If it’s business interest, it can be hard to sell.
  2. Enterprise value. There are times when assets are rising and falling. Sometimes, assets can be in a freefall. A concentrated position can place your economic freedom at risk. There are times when assets actually fall to a value of zero.
  3. Tax liabilities. This is what causes most people not to sell. They don’t want to pay taxes. But this tax avoidance stance can hurt your ability to properly manage your overall asset picture.
  4. Concentration risk. If much of your net worth is in a single security or a single asset class, it is the opposite of diversification.
  5. Opportunity cost. You may be missing out on another opportunity because you are concentrated in a single position.

 

Advantages to a highly concentrated position

I mentioned unlimited upside. There is no limit to how high a security, a business, a piece of real estate, can go.

  • There is the issue of tax deferral. During that period of time that you’re holding the asset and it is going up in value, you are deferring taxes to some point in the future.
  • Also, sometimes, with a concentrated position where you have a business interest, you could have job security. This could be the business that you work at. It’s providing an income for your family, and that is an advantage of a highly concentrated position.
  • And lastly, there can be tax advantages to highly concentrated positions. Real estate has tax advantages. Businesses have tax advantages. So, certainly, there are risks and advantages to highly concentrated positions.

 

Emotional mistakes that people make with this type of asset

  1. They have no plan of action. No financial plans, no tax plans, no legacy plans. There has been no planning.
  2. There may be a knowledge gap. You just don’t know what you don’t know, so it is easy to get yourself trapped into thinking that you can’t do something, you can’t sell something, you can’t sell a portion of something, because you’re missing out on some knowledge.
  3. You’re emotionally tied to that asset. Many people were emotionally tied to General Motors when it was a high-performing stock, the same thing with General Electric, two stocks that performed well historically but not doing so well of late.

Two stocks that are doing well of late are Apple and Amazon. Many people are emotionally tied to these stocks and believe that the future is going to be exactly as the recent past where the stocks do one thing and one thing only, and that is to go up. So, recent history can be an emotional mistake in terms of a highly concentrated position.

Tax liabilities are another issue that come in play here because many people just don’t want to pay taxes. Overconfidence in your knowledge of the situation around that business can be an emotional mistake. Procrastination certainly can be a mistake, and, lastly, the only asset class and real estate comes to mind when I think about this…the only asset class you have ever made money in is real estate. So, therefore, all of your concentration is in real estate, and you don’t have any diversification outside of real estate. That can be an emotional mistake that people make.

 

Things to consider with a highly concentrated position

Your personal timeline

Your retirement, your age, and your mortality. No one is getting out of this life alive. We are all going to come to pass at some point in time, and we need to think about our personal timeline and those in our lives that we care about when we are considering the disposition of a highly concentrated position.

 

Your spouse

Second, partners, your spouse, and their ability to manage the asset if you were not there. We talk about getting hit by the proverbial bus. This is very important when it comes to business interests when you have a spouse who may not be working in that business.

 

Your business interests

Now, speaking of business interests, another issue to consider, if you have a minority ownership or you’re in joint ownership with someone else, is whether or not you have a buy-sell agreement. One of the things that can support is buy-sell agreement can be life insurance.

 

Your legacy

Number four, your legacy, your heirs, and their ability to be able to manage the asset in the future.

 

Your controlled exit

And then the last issue to consider is a controlled exit. A controlled exit is a well thought through plan in order to be able to dispose of the highly concentrated position on a long-term basis.

 

Closing

Now, highly concentrated positions are a great way to build wealth. Not so great at maintaining it, in some cases. Every situation is different, every asset class has its own set of issues, but you are in control if you exercise that control.

Before I get to the action steps from today’s podcast, I want to once again frame this in the context of economic freedom. That’s why you listen to this podcast. That’s what we’re striving to achieve.

And certainly, once you have achieved economic freedom, don’t want to let it slip away because you have a highly concentrated position on your balance sheet. So there are many things that you need to think about going forward if this situation is one you find yourself in.

 

Action steps

Here are some action plans from today’s podcast, and a reminder. I will be doing some follow-up podcasts in this series on highly concentrated positions when I talk about equities, fixed income, real estate, and business ownership interests. Here are our action plans from today’s show.

  1. Have a detailed financial plan that addresses the asset.
  2. Have some risk management in place. That risk management could be a line of credit. That risk management could be life insurance. That risk management can happen if you think through how you can manage downside risk with a particular asset.
  3. Discuss often, at least annually, the disposition of the highly concentrated position with your spouse and key advisors.
  4. Get multiple points of view. Don’t just talk to people who agree with you. Actually seek out people who don’t agree with you to hear their argument as to why you should go down another path with a highly concentrated position.
  5. Have a team of financial advisors. This would include a certified financial planner, a CPA, and an attorney.
  6. Lastly, talk through an exit plan. Now, that exit plan may not need to be exercised on a short-term basis or even a long-term basis, but at least it is being considered.

More to come on this subject when we do a deeper dive on the four asset classes of highly concentrated positions.

This is Doug Fabian. Thank you for listening.

Announcer: The Science of Economic Freedom is intended as an investor education resource. The views and opinions expressed on this program should not be construed as a recommendation to buy, sell, or hold any specific security. Consult your investment advisor and read any investment prospectus carefully before making any changes to your investment portfolio.

This program is sponsored by Mercer Advisors. Mercer Global Advisors, Inc. is registered with the Securities and Exchange Commission and delivers all investment-related services. Mercer Advisors, Inc. is the parent company of Mercer Global Advisors, Inc., and is not involved with investment services.

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