Episode 29 – The Moment to Diversify

[THEME MUSIC]

Welcome to Market Perspectives, a Mercer Advisors podcast. Today’s episode is the moment to diversify. I’m Josh Zumbrun and I’m the Director of External Communications here at Mercer Advisors, and I’m joined by our CIO, our Chief Investment Officer, Don Calcagni. Don, thanks so much for being here today.

Great. Thank you Josh. It’s great to be here.

So Don, let’s dive right into this. Start us off. Why are we talking about diversification now? My investments look great right now. Set the context for us with the current market why this is the moment to talk about this?

The first thing I would say is I think always thinking about diversification is critically important, but it’s particularly important at the moment, given just where we’re at in this particular market. The market is at all time highs. The bull market is looking a little gray. Valuations are near or at their all time highs.

If you actually look at the valuation today of the S&P 500 index, it rivals where we were in the late ’90s during the technology bubble for those of us who are old enough to remember that, stocks were trading at nosebleed valuations in the late ’90s. You could argue today they are very much trading at nosebleed valuations.

Today’s market is really priced for perfection. And the reality is, Josh, even for investors who are already diversified, maybe they own an S&P 500 index ETF or a mutual fund or something like that. We have seen dramatic gains in U.S. stocks over the past several years. Indeed, over the past decade, 10 to 15 years, we’ve seen really dramatic gains in U.S. stocks. So many investors, not just corporate executives, perhaps that own tech shares, but many investors today are sitting on some pretty significant unrealized capital gains.

Now, unrealized is really one of the keys here. What’s an unrealized gain that people are sitting on? What do they need to do? Why do they need to think about that a little bit differently?

So an unrealized gain is gain in your portfolio that has not yet been taxed by the IRS. And we are specifically talking about taxable assets that are not held within an IRA or a 401(k). We’re talking about that joint tenant account that you may have with your spouse or maybe it’s just an individual account that’s only in your name. Maybe it’s a revocable trust account that you have set up as part of your estate planning.

So an unrealized gain is calculated by looking at the fair market value of your investment. Let’s call it stock in Coca-Cola maybe, and you subtract what you paid for that investment plus any reinvested dividends because you’re going to pay tax on your dividends along the way. If you reinvested those dividends, that becomes part of what we call your basis.

Basis is just a fancy tax term for what you effectively paid to buy the investment. So fair market value minus your basis that’s your untaxed gain. Unrealized is the fancy tax term for that part of your gain that has not been taxed.

And we know that right now when the market is up like this, there’s a lot of people in that situation where maybe they were paid in a company stock, or maybe they just made an investment 10 years ago that has performed really well, and so now the market’s sky high and that looks terrific on paper, but if you go to do something with it you’re worried like what’s the tax rate going to be?

So if you’re sitting on a big unrealized gain, why do you want to get out of that versus just like letting that winner continue to ride, because I think that’s the first question for a lot of people. Hey, this investment has performed great, why do I want to switch out of this in the first place?

This is the biggest challenge I think that we have as advisors is convincing clients to do something different from what has worked over the more immediate period. We love to hold on to our winning stocks. Our view is, wow, wait, it’s doing so well why would I suddenly make a change.

And I would encourage us to think about it a little differently. A stock is never doing well, a stock has done well. Even as of this morning, at say, 10:03 a.m. when you look at the gains on your Amazon, Apple, NVIDIA, whatever it is, those gains are in the past. There is no guarantee that over the next 30 seconds, 10 minutes, or over the next five years, that stock is actually going to continue to do well.

And in fact, Josh, when we actually look at all of the data, when we look at all of the stocks that have ever been publicly traded over the past 100 years, one of the things we observe is that all of the stock market’s gains over the past 100 years have come from only 4% of the stocks that were ever publicly traded. Think about that. 96% of stocks that were publicly traded, either currently or at some time in the past, actually lost money, or were flat, or were acquired, or were delisted. So if you think about that, the odds of selecting that 4% of winning companies is very, very low.

And Don, I think those 4% of companies that have been big winners, it’s changed a lot over time. It’s not the case that it’s just a matter of picking the top company in the market and sticking with it. One of the things we’ve seen is once you get to the top, it’s hard to stay there.

That’s absolutely right, Josh.

Just looking back over the past five years, if we go back to 2020. If we look at who were the big winning stocks in 2020, it was companies like Procter & Gamble. It was during the pandemic we were all rushing out and buying toilet paper, and paper towels, and things like that and Clorox and things like that, but Procter & Gamble, J.P. Morgan, General Electric, Wells Fargo, ExxonMobil, Johnson & Johnson, these were all big winners.

As recently as five or 10 years ago, none of them are the big winning stocks of 2025. And in fact, Josh, if we go back just a little bit further, if you go back to 2000, for example, and you look at the top 10 stocks in the year 2000, only one of them is a top 10 stock today and that is Microsoft. The other nine companies are not in the top 10 in 2025. So your point, market leadership does change and it does change dramatically, not just over longer periods of time, but even over shorter horizons as short as two to three, to five years.

It’s funny to look at that list of the top companies in the year 2000. GE, Cisco, Walmart, ExxonMobil, Intel, Lucent, IBM. At the time, you would have said, these stocks are doing great, your point from earlier, and you would have said, these have to be the companies of the future.

Absolutely. And yet again, we see this pattern repeat itself. And we would have been wrong. 25 years on, we have almost completely new set of companies that are leading today’s stock market.

So now that makes a good case for diversification, but when we talk about diversification, what are we actually mean? Walk us through how we ought to think about diversification.

So, Josh, I think it’s important to think about diversification along three different dimensions or at three different levels. And I think number 1 is, you want to think about diversification at the financial plan level.

Every investor should have a financial plan.

And our financial plans should be flexible. It’s one thing to say I want to retire at a certain age, I want a certain lifestyle, a certain income or whatever the case may be. And that’s totally fine. You should have plan A, we all have plan A, but we absolutely should have a plan B, a plan C, and a plan D. Life changes. Life throws us curveballs.

Perhaps a spouse is diagnosed with a terminal illness or maybe you need to suddenly set up a special needs trust for a child, or maybe there’s a new grandchild that comes into the world and suddenly those things force you to rethink the plan. And so making sure that your financial plan is well diversified in terms of the different outcomes, the different strategies that you’re deploying from a planning perspective, I think is really the first layer of diversification in my view.

The second layer of diversification is what we traditionally think of when we’re thinking about investment diversification. And when it comes to investment diversification of our portfolios, we want to think about that within asset classes.

So for example, maybe you own Apple.

Well you certainly want to diversify within technology stocks. You should own more than just Apple, but you should also own more than just technology stocks, maybe consumer staples, and real estate, and financials, and so on and so forth. And that’s what we call diversifying across asset classes.

So this second layer is one of our key investment principles at Mercer Advisors, and that is we want to diversify within but also across major asset classes. So that’s the second level. That’s what most of us think about.

This third level, most folks do not think about. And that has to do with diversifying across strategies. There are lots of strategies for how to manage and diversify that unrealized capital gain that we were talking about a few moments ago.

Some of those strategies use options for example, others use partnership structures and take advantage of provisions in the Internal Revenue Code. The reality is, all of these strategies perform differently over time. Things change, tax laws change, markets naturally change, and so the prudent thing to do is to also diversify across strategies and that really completes really this three layers of diversification for how we think about it here at Mercer Advisors.

Don, let’s dig into that final one just a little bit because that’s really interesting. We don’t hear nearly as much about that as you hear about just owning a broad range of stuff. The strategy component of it is a really important piece though, I think.

So we know a common situation right now is people who are sitting on these huge unrealized gains. And even once they accept that it might be a good idea to diversify, there’s an important question of how you do that. And so walk us through some of the options that are available.

If you’re in that situation, you have this huge unrealized gain. You want to diversify it, you don’t want to pay the entire tax hit in one calendar year. And so what are some of the options available to you to manage that situation?

There’s a lot of strategies Josh, to manage that. And so the first thing I would say is we absolutely agree at Mercer Advisors the only returns that matter on your investment portfolio or the ones you get to keep. So if ultimately, we sell a position and we have to send a big check to the IRS, that hurts, that doesn’t feel very good.

So the question is, ultimately, how do we minimize or ideally defer or even avoid the tax hit as part of this diversification process? The first and most obvious one you already mentioned could style the shares and pay the tax hit, but one of the things you could do, is you could style those shares over time and stretch it out across multiple tax years. We call that staged selling. You sell some now, you sell some next year, the year after, and so on and so forth.

And in that way, you could also time, perhaps your sales when you are expecting to potentially be in a lower income tax bracket. So that’s very common. You see lots of folks do that. There’s really no sizzle to that. It’s not very sophisticated, but that is one approach is to slowly just pay the tax hit and stretch it out over time.

And it potentially saves a lot of money. If you pay everything at the top tax rate versus splitting it across a few years, all of it in a lower tax bracket, that actually is significant.

Absolutely right. What we often find is that folks, as they stop working and transition into retirement, is they slowly fall into lower and lower tax brackets. And so that actually offers an opportunity to realize capital gains potentially at a lower tax level. And there’s actually one income tax level where there is no capital gains tax, depending on where you’re falling in terms of your taxable income for any given year.

But Josh, there’s other strategies. There’s strategies where you don’t have to pay tax and you can still diversify. One of the things that’s very simple that I see many investors just totally miss is you could simply continue to invest in your IRAs, and your 401(k)s, and other tax sheltered vehicles, and then continue to build highly diversified portfolios within those accounts. And that actually helps to diversify the balance sheet.

So even if you have $10 million, for example, on Apple stock in a taxable account, you can still do these other things and help diversify the balance sheet.

But there are certainly more sophisticated tax planning strategies, Josh. For example, you could use a long-short strategy. This is a strategy where the strategy uses margin. It shorts a bunch of stocks, it goes long a bunch of stocks. And if you think about what that has done, is it actually significantly increases the number of positions in the portfolio where tax loss harvesting could be an option.

So a long-short strategy is really banking on the ability to harvest losses in parts of the portfolio to ultimately use to offset gains harvested elsewhere across the client’s balance sheets.

And these long-short strategies have become very popular in recent years. They work well, but this is where I go back to my point on diversifying across strategies. They’re certainly not for everybody, and there’s always a possibility that something could go wrong in that particular strategy.

And so this point around diversifying across strategies is really about keeping our overconfidence biases in check. As humans, we tend to get really, really excited about one idea, one stock or one strategy. And that can be really detrimental to our broader financial plan.

And so long-short strategies, awesome strategies. We use them here at Mercer Advisors, but I think they’re best paired with other strategies. For example, an exchange fund. An exchange fund is a private partnership where we can actually contribute low basis stock and immediately diversify that risk exposure across all of the stocks held by that private partnership or what we call an exchange fund.

There’s lots of other strategies. There’s opportunity zone funds that invest in real estate where we can even avoid taxation on part of our capital gain if we hold that investment over a certain period of time.

So opportunity zone funds, there’s also charitable planning strategies Josh, charitable remainder trusts for example. There are so many tools out there in the toolbox that investors would be wise to diversify across those tools instead of loading up exclusively on just one tool and banking their whole balance sheet on just one strategy.

These are obviously advanced investing situations where you’d find yourself considering this. And I guess the risk is you wrap your head around one strategy and say, I get this one, let’s go all in on it. And it’s actually a variation of not diversifying problem that you have when you go all in on one stock. You want to figure out the whole broad range of things and put your eggs in different baskets.

That’s exactly right. And just like it is optimal to diversify across many, many stocks and many asset classes, most of the time, it’s optimal to diversify across these different types of tax planning and investment strategies. And working with a sophisticated advisory team, you could actually engineer the optimal mix of strategies for your family and for your particular balance sheet.

And when you do that further de-risk not just your balance sheet, not just your portfolio, but you de-risk the possibility that your family will not achieve its longer term goals. And that ultimately, Josh, that’s what we’re solving for, is providing for our lifestyle, providing for our families, either the current generation or across multiple generations. When you use all of these different strategies together, what you’re doing is you’re de-risking the probability of an adverse outcome for you and your family.

So, Don, to wrap this up, what’s your message to investors right now who as an investor ought to be thinking pretty hard about this in our current moment?

Certainly all investors Josh, should be constantly thinking about diversification, but I think at a broader level, we should always be thinking about how do we de-risk our balance sheet? How do we de-risk our financial plan and really ensure the future economic security of our families? And so I think everybody should be thinking about this.

Certainly people who have unrealized gains in their balance sheets should absolutely be thinking about these things. And certainly at this point in time, we said, given where market valuations are at, given where economic uncertainty is that in terms of all of the changes that are transpiring across the US and global economy at the moment, the prudent thing to do is to diversify within our financial plan, diversify within our portfolios, but then also to diversify across strategies to really de-risk the probability of an adverse outcome later in life.

Don, thanks so much for being here today to have this conversation.

Thank you Josh. It was a great conversation.

If you’re already a Mercer Advisors client, don’t hesitate to reach out to your advisor, especially if you’re sitting on a big concentrated position with an unrealized gain and you’re trying to figure out your strategy, it’s a great time to get moving on it. And if you’re not a Mercer Advisors client but you’re interested in more information, go to our website, merceradvisors.com, it starts with a phone call. This has been Market Perspectives.