How much do you lose by not diversifying your investments


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Editor’s Note: This story originally appeared on SmartAsset.com.

Whether you have inherited shares, acquired shares in your company, or simply only have a few holdings, a highly concentrated portfolio can cause you to lose significant wealth through lack of diversification.

Recent research by Dimensional Fund Advisors (DFA) shows that liquidating a concentrated portfolio with relatively few holdings and moving into a diverse portfolio of investments will produce more wealth in the long run, despite generating a tax bill initially.

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DFA دراسة Study Results

Using a hypothetical investor with a portfolio of five stocks valued at $1.5 million, DFA determined that the value of the portfolio would be nearly double its value after 25 years if the investor moved to a more diversified set of holdings with higher expected returns.

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

Of course, there can be a big tax arriving in advance. However, she continued, “the less tangible costs of not moving, in terms of what the investor may forgo in the future, may be greater.”

focus vs diversification

How much would an investor give up by not moving into a broadly diversified portfolio with more holdings? To answer this question, the DFA compared the 25-year forecast for a concentrated portfolio of $1.5 million with a pair of hypothetical alternatives.

In both alternative scenarios, the investor liquidates an existing portfolio, pays capital gains taxes, and then reallocates assets to a more diverse set of holdings.

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

Assuming a capital gains tax rate of 25%, both options 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 a portfolio of five stocks, which greatly improves their compound returns over time.

As a result, alternative portfolios generate millions of dollars more than a highly focused portfolio, according to the DFA.

Here is a look at the investor’s current portfolio and its outlook for 25 years:

  • 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 taxes and after liquidation): $4,144,189

Here’s a look at Transition A and its prospects over 25 years:

  • 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 taxes and after 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 taxes and after liquidation): $7,784,609

While the current portfolio would be worth $4.1 million by 25 years, the investor would forgo $2.1 million in potential growth by not choosing Transition A.

The opportunity cost will be greater compared to Transition B, which could be worth up to $7.7 million in 25 years.

“Diversification is integral to strong portfolio design and increases the likelihood of obtaining premiums and outperforming the market,” Hendricks wrote. However, there is no reliable way to predict which securities will offer a premium in a given period. Therefore, focused investment solutions may miss stocks that offer premiums.”

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DFA research points to a variety of benefits associated with diversified portfolios, including lower volatility and an increased likelihood of premium returns.

An investor with a $1.5 million portfolio consisting of just five stocks would make an additional $2.1 million over 25 years by moving to a diversified portfolio with similar returns.

Meanwhile, moving to a diversified portfolio that seeks moderately higher returns over 25 years would leave the investor $3.6 million more than concentrated allocations.

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