Don’t put all your eggs in one basket. This is not just good guidance for those of us trying to keep the peace at home with our kids this Easter. The need to diversify is so foundational to financial advice that it can seem absurd to even question it. But sometimes clients question us in ways that should make us rethink the seemingly obvious. Here’s what happened to me.
It was sometime in mid-2009 when a colleague and I were meeting with this prospective client for the first time. He was part owner of a ski resort in the Rocky Mountains as well as an investor in several rental properties.
He explained how he had the opportunity to sell three years earlier (in 2006) and was advised to do so at the time by an advisor who told him he had too much of his wealth tied up in the business and that he needed to diversify.
The prospect went on to explain that, had he done so, he not only would have missed out on double digit growth in his company over the subsequent years, but he would have lost millions by investing in a supposedly less risky, diversified portfolio of stocks and bonds just prior to the financial crisis of 2008/2009.
Frankly, it was a tough argument to refute. Yes, hindsight is 20/20. And, sure, I could have explained how 2008/2009 was a one hundred year flood scenario and that a financial crisis of that sort is unlikely to occur again in the near future. Still, despite what we might reflexively point out using the typical Ibbotson and Callan charts, he was making a deeper point that needs to be acknowledged.
For a certain subset of clients – more affluent, entrepreneurial people who are in growth mode and not planning to live off of their portfolio anytime soon – the best strategy may be to concentrate their investments. I’ve worked with a lot of business owners over the years, as well as quite a few real estate investors, and they tend to concentrate their wealth in these closely-held assets for a period of time.
These clients often create wealth through a heavy concentration of time, money, and talent in business interest and real estate interests. The same is true of corporate executives whose asset base is often disproportionately tied to one company.
That is not to say that diversification does not apply to these people or that mitigating the risks of these investments is not important. However, the fact remains that many high net worth clients have amassed their wealth this way.
The short way to say it is that wealth is often accumulated through concentration and preserved through diversification. Business owners and real estate investors in particular are much more comfortable taking risks in their own ventures because they understand the investments and – to a much greater extent than passive investments – have control over those investments.
Think about what has to happen for someone to start a business in the first place. They need to overcome all of their instinctive fear and and desire for security to put it all on the line. They have to believe enough in their idea and ability to execute that they step out without a net. If they succeeded, it was (at least in part) because they were able to silence that "diversifying" voice in their head in order to place a big, risky bet on themselves.
So when a successful entrepreneur hears an advisor predictably lecture him about taking too much risk, he is thinking, "What do you know? By that same logic, I never would have taken the leap and been successful in the first place. I wouldn't be here if I had listened to people like you."
You don't won't to be one of those people. Business owners are realists who learn by doing. They tend to be dismissive of those people who "know" things based on theories and concepts.
The much more effective – and wiser – counsel is to formulate advice in these situations more around life stage. A client who is transitioning (now or in the next several years) to retirement needs to begin to shift focus from accumulating wealth to distributing wealth, which involves converting a largely illiquid asset base into a stream of income that will last for the next 30 years or more AND keep up with inflation.
That will involve a big shift in the way the assets are constructed. In other words, “what got you here, won’t get you there.” So, yes, I am talking about diversification in this case. But notice I didn’t even say the word.
Even if the end result – at least in this case – is the same, it is vitally important how we talk about it. An advisor who is able to adapt to the mindset and experience of the client is rightly perceived as someone who "gets it" and who understands them. A one-size-fits all recommendation to diversify is not always going to achieve that goal.