(Photo Credit: ironrodart)

Capitalism is the single largest wealth generator in the United States. Whether in the small business sector or the Fortune 500, our open and innovative society has enriched the populace more than anywhere else on the planet.

Historically, concentrated equity positions have been a road to personal wealth.

Maybe you built up a private business, inherited a big chunk of stock, or picked a great stock that you held through thick and thin to a fantastic level of wealth. Congratulations, you are the American Dream!

Now that you’ve made it, can you keep it?

When It’s Time To Change Strategies

Oftentimes, what gets you to a goal is different from what preserves or improves upon those results. For example, boot-strapping entrepreneurs who focus on business creation and growth, typically step aside for a risk-averse manager once the business has matured. What was once a startup, is now a complicated organism that can be destroyed by taking on too much risk.

In escense, preservation and incremental improvement become much more important than continuing to take on life-or-death risks that were critical during the growth phase. Defense takes over where offense left off. Similarly, a time arrives when overly concentrated investments should give way to greater diversification.

While concentrated investments can create wealth, it is incredibly difficult to stay wealthy by remaining concentrated. As net worth substantially increases, the benefit of large gains takes a back seat to protecting against the pain associated with a rapid and significant decline.

Once wealthy:

– How would life change if you incurred a 50,60, or 80% decline in net worth?

– How would it impact your relationships with family, friends, and social groups?

– How would it impact you personally?

It Can Happen To You

Of course, most of us think, “It couldn’t happen to me,” because we are confident in the wonderful investment that helped us achieve wealth. However, overly concentrated positions are like Russian roulette.

Every morning the holder of such a position pulls the trigger. The hammer may come down on an empty chamber today, but somewhere else it is striking a bullet, be it an astonishing accounting fraud at Enron, the blowup of century-old Lehman Brothers, or the quiet collapse of a smaller sized firm.

Lives of investors who were overly concentrated, suffered terribly from these colossal failures.

Due to the creative destruction of capitalism, no company is invincible, untouchable, or permanent. Consequently, an overly concentrated equity position is truly a gamble. The bet is that creative destruction does not apply to our specific investment, and worse, it is a bet with our vast fortune on this wildly improbable thesis.

The worst part is that this strategy can feel right for a very long time, just up to the point where it is wrong in a very bad way….and then it is too late.

The Solution To This Problem Is Diversification

The bargain works like this: if you diversify, you won’t make a killing, and in return you won’t get killed. Diversification can be accomplished in three steps:

1) Reduce your concentrated position down to no more than 5-10% of your net worth

2) Maintain a few years worth of budget in cash

3) Reinvest your holdings into uncorrelated investments

Of course, there can be complications. Reducing your concentrated position can be challenged by an illiquid private business ownership, lock-up periods on stock or option grants, or large built-in taxable gains. Furthermore, finding diversifying investments (public, private, etc.) may not be your core skill-set.

If you or a friend is in an overly concentrated position, take action today and secure your lifestyle. If you can do it yourself, great!

If you would like expert assistance, contact an LGA Advisor to develop and implement a plan that works.

Don’t let calamity strike before you diversify!