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An investor checks his portfolio on his phone. Research from Dimensional Fund Advisors points to the long-term benefits of diversification.

Whether you’ve inherited stock, received equity in your company or simply own only a few holdings, a highly-concentrated portfolios may cause you to miss out on significant wealth by not diversifying.

Research from Dimensional Fund Advisors shows that liquidating a concentrated portfolio with relatively few holdings and transitioning to a diversified set of investments would produce more wealth in the long run, despite initially generating a tax bill.

A financial advisor can help you select asset allocation aligned with your objectives. Find an advisor today.

DFA Study Findings

Using a hypothetical investor with a five-stock portfolio worth $1.5 million, DFA determined the portfolio would be worth nearly twice as much after 25 year if the investor transitioned to a more diversified set of holdings with higher expected returns.

“Incurring capital gains tax is a tangible cost investors face in transitioning to a well diversified portfolio,” DFA researcher and vice president Kaitlin Simpson Hendrix wrote in a 13-page report titled “SMAs: Quantifying the Tradeoffs Between Taxes and Diversification.”

Of course, there can be that sizeable tax hit upfront. Yet, she continued, “the less tangible costs of not transitioning, in terms of what an investor may be giving up in the future, may be greater.”

Concentration vs. Diversification

A couple checks on their investments together. Research from Dimensional Fund Advisors points to the long-term benefits of diversification within a portfolio.

Just how much is an investor forgoing by not transitioning to a broadly diversified portfolio with more holdings? To answer this question, DFA compared the 25-year outlook of a concentrated $1.5 million portfolio to a pair of hypothetical alternatives. In both alternative scenarios, the investor would liquidate his existing portfolio, pay taxes on his capital gains and then reallocate his assets to a more diverse array of holdings.

The first alternative portfolio, referred to as Transition A, maintains the same expected rate of return as the existing portfolio (9%) but has more holdings. The second alternative, dubbed Transition B, focuses on stocks with higher expected returns (10%).

Assuming a capital gains tax rate of 25%, both alternatives would generate a tax bill of approximately $125,000, leaving the investor with a cost basis of $1.375 million. However, both benefit from lower volatility compared to the five-stock portfolio, which dramatically improves their compound returns over time. As a result, the alternative portfolios produce millions of dollars more than the highly concentrated portfolio, according to DFA.

Here’s a look at the investor’s existing portfolio and its 25-year outlook:

  • Initial portfolio value: $1,500,000
  • Cost basis: $1,000,000
  • Tax rate: 25%
  • Expected return: 9%
  • Volatility: 30%
  • Total wealth in 25 years (after-tax, post liquidation): $4,144,189

Here’s a look at Transition A and its 25-year outlook:

  • Initial portfolio value: $1,500,000
  • Cost basis: $1,375,000
  • Tax rate: 25%
  • Expected return: 9%
  • Volatility: 20%
  • Total wealth in 25 years (after-tax, post liquidation): $6,222,259

Here’s a look at Transition B and its 25-year outlook:

  • Initial portfolio value: $1,500,000
  • Cost basis: $1,375,000
  • Tax rate: 25%
  • Expected return: 10%
  • Volatility: 20%
  • Total wealth in 25 years (after-tax, post liquidation): $7,784,609

While the existing portfolio would be worth $4.1 million by the 25-year mark, the investor would forgo an $2.1 million in potential growth if they didn’t opt for Transition A. The opportunity cost would be even greater compared to Transition B, which would be worth $7.7 million in 25 years.

“Diversification is an integral part of robust portfolio design and increases the probability of capturing the premiums and outperforming the market,” Hendrix wrote. “However, there is no reliable way to predict which securities will deliver the premium in a given period. Therefore, concentrated investment solutions may miss out on the very stocks that deliver the premiums.”

Bottom Line

A financial advisor shows a client a potential asset allocation. Research from Dimensional Fund Advisors points to the benefits of diversification.

The DFA research points to a variety of benefits associated with diversified portfolios, including lower volatility and increased probability of capturing premium returns. An investor with a $1.5 million portfolio that comprises just five stocks would stand to make an extra $2.1 million over the course of 25 years by transitioning to a diversified portfolio with similar returns. Meanwhile, transitioning to a diversified portfolio that seeks even moderately higher returns over 25 years would leave the investor with $3.6 million more compared to the concentrated allocations.

Investing Tips

  • Taxes can play an important role when it comes your investing strategy. How much you may owe in capital gains when you sell an asset is valuable information that may inform your decision. SmartAsset’s Capital Gains Calculator can help you determine how much your tax bill may be.
  • A financial advisor can provide valuable insight and guidance when it comes to the asset allocation and management of your investment portfolio. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

Photo credit: ©iStock.com/tdub303, ©iStock.com/PeopleImages, ©iStock.com/simonkr

Patrick Villanova Patrick Villanova is a writer for SmartAsset, covering a variety of personal finance topics, including retirement and investing. Before joining SmartAsset, Patrick worked as an editor at The Jersey Journal. His work has also appeared on NJ.com and in The Star-Ledger. Patrick is a graduate of the University of New Hampshire, where he studied English and developed his love of writing. In his free time, he enjoys hiking, trying out new recipes in the kitchen and watching his beloved New York sports teams. A New Jersey native, he currently lives in Jersey City.
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