I recently received a phone callfrom John Smith, MD, a physician-investor who is concernedabout the volatility in his investmentportfolio. Dr. Smith informed methat it's not unusual for his portfolio toexperience daily swings of $250,000either up or down.
Upon investigating the individualholdings within his portfolio, I foundthat he had only 21 individual equitypositions. 65% ofthe entire portfolio was concentrated inone stock. In addition, there were nofixed-income positions within the portfolioto buffer the volatility inherent inthe stock market. To make matters evenworse, Dr. Smith's investments, gifts hereceived from friends and familythroughout the past 41 years, were limitedto only one business sector—andthat's asking for trouble.
To further compound the problem,Dr. Smith is single, specializes in high-risksurgery, and holds the securities ina brokerage account in his name. Andalthough he has little saved in otherinvestment vehicles or his 401(k) plan,he is currently contemplating retirement.While he's ready to retire, his savingsaren't mature enough. He will bedependent upon dividends generatedfrom his portfolio to fund his annualretirement income. Fortunately, theportfolio is sizable and currently generatinga 2.7% yield.
Dr. Smith is facing several problems.First of all, since the securities are held inan account in his name, the portfolio isnot protected from creditors in the eventof a lawsuit. Second, if he decides to liquidatethe portfolio for the sake of diversifying,he will have a capital gains taxestimated at approximately $1 million,which will significantly impact the portfolio'svalue and reduce dividends (ie, Dr.Smith's future annual income).
There is another issue Dr. Smithneeds to consider, and that is change.Suppose the one security that constitutes65% of his portfolio and generatesabout two thirds of the dividendincome he annually receives starts givingshareholders less. The truth is, thecompany's board of directors, for whateverreason, could decide to reduce thedividends paid to shareholders. Ofcourse, it could be worse and the companycould eliminate dividends altogether,in which case Dr. Smith wouldbe up a creek with no paddle.
Fixing these problems can posequite a challenge. There is no easy fixthat fully addresses or solves the issuesregarding diversification, taxes, dividendpreservation, and risk. However,the impact of these problems on theportfolio may be tempered.
Most investors would begin makingadjustments by first determining the costbasis of each holding in their portfolio.By determining cost basis, they're able tofigure out capital gains taxes on the individualsecurities. Then, through somethingknown as tax-loss harvesting,they'll reduce or eliminate the capitalgains taxes. However, this strategy doesnot fix portfolios that are very concentrated,such as the one Dr. Smith has.
In this case, Dr. Smith should keep hiscore holding (ie, the security that constitutesnearly 65% of his portfolio), butsell enough shares so that it onlyaccounts for 45% to 50% of the overallportfolio. He should systematically disposeof the remaining securities, employingtax-loss harvesting to minimize theimpact of capital gains taxes. Andbecause Dr. Smith is nearing retirementwith an account that isn't tax-favored ortax-deferred, he should include municipalbonds and international equity in hisportfolio. The last component of theportfolio should be hybrid securities,such as preferred equity.
Even though at this stage the transitionis complete, Dr. Smith needs tokeep in mind that a sudden surge ininterest rates will impact fixed-incomesecurities and preferred equities. Itshould take Dr. Smith a few years tomake all of these changes.
Dr. Smith's Exceptions
Did you notice anything in particularabout Dr. Smith's portfolio? Onething you might have noticed is that itcontains individual securities as opposedto mutual funds. Toreduce costs and avoid capital gains,which are present in individual mutualfunds. In addition, the investmentsfocus on value-oriented stocks, whichgenerate cash dividends, and notgrowth stocks, which usually don't generatedividend income.
By avoiding capital gains taxes andthe costs associated with mutual funds,it will be relatively easy for Dr. Smith togenerate his annual dividend income.In fact, the portfolio we constructedwill generate a yield—net of any portfoliomanagement fees—that exceedshis current yield of 2.7%. Also, byemploying tax-loss harvesting, Dr.Smith should be able to decrease hiscapital gains from $1 million to about$300,000. Finally, it is estimated thathe will decrease the portfolio's volatilityand risk by more than 50%.
and his partner,
Harris L. Kerker, are principals of
the Asset Planning Group in Miami,
Fla, specializing in investment,
retirement, and estate planning. Mr.
Kosky teaches corporate finance in
the Saturday Executive and Health Care Executive
MBA Programs at the University of Miami. He welcomes
questions or comments at 800-953-5508, or
Thomas R. Kosky