IronBridge Private Wealth

Forward with Confidence

Planning for 2022: The IRS has Increased Several Key Deductions, Exemptions and Contribution Limits

The spike in inflation we’ve seen this year has impacts beyond having to pay more for goods and services. The IRS uses consumer price inflation (CPI) to determine certain increases to exemptions and deductions for federal tax purposes. These are automatic and calculated from the rise in CPI.

That means that the increased inflation this year may actually end up saving you money.

While the changes are for 2022 and you won’t be paying the associated taxes until 2023, it’s a good idea to be aware of the new limits.

You may be able to make changes as you go that can help you maximize the benefit.

For example, the amounts for Flexible Spending Accounts (FSAs) and the commuter benefit increased. You may want to have more taken out of your paycheck to reflect this change. This saves you money by paying with pre-tax dollars for expenses you’re likely to pay anyways.

The income levels at which AMT applies also went up. If you have stock options, AMT very often comes into play. The increase amounts to $2,300 over the 2021 level for a single filer. While it doesn’t seem like much, it may be enough to allow you some flexibility in structuring them that will save you on taxes.

As always, we are not tax advisors. Please consult your tax professional on how these changes may affect your individual situation.

Retirement Contribution Limits

For workplace retirement accounts (i.e. 401(k), 403(b), amongst others), the contribution limit rises $1,000 to $20,500. Catch-up contributions remain at $6,500.1

Eligibility for Roth IRA contributions has increased, as well. These have bumped up to $129,000 to $144,000 for single filers and heads of households, and $204,000 to $214,000 for those filing jointly as married couples.1

Another increase was for SIMPLE IRA Plans (SIMPLE is an acronym for Savings Incentive Match Plan for Employees), which increases from $13,500 to $14,000.1

Unfortunately, not everything changes in 2022.

Traditional Individual Retirement Accounts (IRAs), with the limit remaining at $6,000. The catch-up contribution for traditional IRAs remains $1,000 as well.1

Taking the Standard Deduction

The standard deduction increased in 2018, and many taxpayers now opt not to itemize. For 2022, this choice becomes even more attractive as the deduction for a married couple filing jointly increased by $800. Taking the standard deduction simplifies tax preparation, but if you have deductible expenses such as medical expenses, property taxes, mortgage interest, charitable giving, or others (and there are hundreds), you may be passing up tax savings.

If your total itemized deductions are close to the amount of the standard deduction, there are strategies for charitable giving that can increase your tax deductions in any one year. This can be done without increasing your overall plans for giving. Giving some thought to your deductions as you move through the year can help you keep track of where you want to be.

Alternative Minimum Tax

The alternative minimum tax was created to limit the amount that high-income taxpayers can lower tax amounts through deductions or credits. It sets a floor on the amount of tax that must be paid. The AMT is particularly relevant if you have been granted incentive stock options (ISOs) as part of your compensation.

The AMT is adjusted based on the price you pay for the shares (the strike price) and the fair market value when you exercise. Because you can choose when to exercise, you have some flexibility in avoiding or minimizing AMT, but it requires careful planning of your income.

Flexible Spending Accounts and Commuter Benefits

The dollar limit for 2022 contributions to a flexible savings account is $2,850, an increase of $100 over 2021. If your plan allows carryovers, the new carryover limit is $570.

The monthly commuter benefit contribution limit for 2022 to your qualified parking and transit accounts increased to $280.

Gift and Estate Tax Exclusions

The annual federal exclusion for gifts was bumped up $1,000 to $16,000 for 2022. For a married couple, this means they can gift $32,000 to any individual without using their lifetime exemption.

The lifetime exemption also went up, to $12.06 million per person.

The Takeaway

Increases in deductions and exemptions are one of the few areas that inflation can help out investors – but you’ll need to plan ahead to take advantage of some of the increases.

There are lot of moving parts to a comprehensive plan that can save you money on taxes, and it’s never too early to get started in making the right moves.

1. CNBC.com, Friday, November 5, 2021

The information contained herein is intended to be used for educational purposes only and is not exhaustive.  Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return.  If applicable, historical discussions and/or opinions are not predictive of future events.  The content is presented in good faith and has been drawn from sources believed to be reliable.  The content is not intended to be legal, tax or financial advice.  Please consult a legal, tax or financial professional for information specific to your individual situation.

Once you reach age 72, you must begin taking required minimum distributions from a Traditional Individual Retirement Account (IRA) or Savings Incentive Match Plan for Employees IRA in most circumstances. Withdrawals from Traditional IRAs are taxed as ordinary income and, if taken before age 59½, may be subject to a 10% federal income tax penalty. Once you reach age 72, you must begin taking required minimum distributions from your 401(k), 403(b), or other defined-contribution plans in most circumstances. Withdrawals from your 401(k) or other defined-contribution plans are taxed as ordinary income and, if taken before age 59½, may be subject to a 10% federal income tax penalty. To qualify for the tax-free and penalty-free withdrawal of earnings, Roth IRA distributions must meet a five-year holding requirement and occur after age 59½. Tax-free and penalty-free withdrawal can also be taken under certain other circumstances, such as the owner’s death. The original Roth IRA owner is not required to take minimum annual withdrawals. The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation. This material was developed and produced by FMG Suite to provide information on a topic that may be of interest. FMG Suite, LLC, is not affiliated with the named representative, broker-dealer, state- or SEC-registered investment advisory firm. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security.

Houdini’s Hole

The Paramount Theatre in Austin, Texas is a city treasure. It has an amazing variety of shows, and the list of notable performers is unmatched. It was built in 1915, and began mostly as a vaudeville house.

Just a few of the notable performers in its history are Miles Davis, the Marx Brothers, George Carlin, Ray Charles, Billy Joel, Don Rickles, Chuck Berry, Gladys Knight…the list goes on. Learn more about the Paramount Theatre: https://www.austintheatre.org/

Harry Houdini

One of the most famous performers to grace the Paramount stage was Harry Houdini. And his presence can literally be seen to this day.

Houdini performed there in 1916. At the time, he was one of the most famous people in the world. His slight-of-hand tricks mesmerized audiences worldwide.

One part of his performance was a suspended levitation trick.

He would dangle from the ceiling and escape a straightjacket or chains or some other kind of concoction.

He most likely performed this trick at the Paramount during his eight shows in Austin. To accomplish it, the theater operators drilled a hole in the ceiling of the Paramount and dangled the global superstar over the audience.

The hole they drilled is still in the ceiling today, over 100 years later, as shown in the picture below.

Houdini’s hole can be seen in the green area to the top-right of Saint Cecilia’s right hand. Photo courtesy of the Paramount Theatre website.

The details of Houdini’s trick that night are unknown.

But as with any kind of “magic” trick, it’s not about how the performer escapes. It’s all about distracting the audience to create an illusion of making the impossible possible.

This same type of “magic” is happening in financial markets today.

Suspended Levitation

Harry Houdini mastered the art of the suspended levitation tricks.

In today’s markets, there appear to be two Houdini’s: the Fed and the mega-cap tech stocks (such as Tesla, Facebook, Google, Amazon, Apple and Microsoft).

We’ve discussed the Fed a LOT in these reports.

But we came across a new chart that shows just how big of an impact the Fed may have had in market growth over the past decade.

Bank of America Global Research did some very interesting analysis.

What they did is look at how much of the market growth can be explained by earnings growth, and how much can be explained by the Fed’s balance sheet.

The first chart below shows how much of the returns of the S&P 500 can be explained by changes in the earnings of the companies within the index.

Earnings Contribution to changes in the S&P 500 Market Cap

This chart paints an interesting picture.

Traditional investors assume that when earnings increase, so should the stock price. That’s what we’re buying after all, right? Shares in a company whose business should grow?

But the chart above tells us that’s not quite the case.

It tells us is that from 1997 to 2009, only 48% of the changes in the index can be explained by earnings growth.

And after the 2008 Financial Crisis, earnings only accounted for 21% of the changes in the S&P 500!

That’s pretty amazing. Only 21% of the increase in the market over a decade-long period is due to earnings?

What would explain the rest of the growth?

There are a variety of things that impact stocks:

  • Earnings: Higher profits or revenue can lead to more valuable companies.
  • Flows: More money chasing stocks makes it go higher, less money makes it go lower.
  • Sentiment: Optimism creates more buyers, while pessimism means more sellers.
  • Investing Alternatives: When stocks have competition for returns, less money goes into the stock market.
  • Liquidity: When there is more money in the system, there is additional capital to put to work that is not tied up in other areas like inventories.

We could write dissertations about each of these categories.

But let’s focus on the last item, liquidity. This is the main avenue where the Fed has an impact.

Fed-Driven Market Growth

Bank of America also did the analysis on how much of the price changes can be explained by changes in the Federal Reserve balance sheet, which is shown in the next chart.

Fed Balance Sheet Contribution to changes in the S&P 500 Index

Here we really start to understand just how much impact the Fed has on markets.

From 1997 to 2009, literally zero percent of the return of the S&P 500 can be explained by changes in the Fed balance sheet.

Granted, the Fed’s balance sheet wasn’t that big before the financial crisis. But that’s kind of the point.

Since 2010, a whopping 52% of market performance can be attributed to the Fed. That’s even more of an impact than EARNINGS had in the 12 years leading up to it.

No wonder the Fed is nervous about what happens when they start to reduce the size of the balance sheet. (Read our article earlier this year The Fed is Stuck.)

They are creating an illusion, just like Houdini.

What started in 2009 as proper policy to keep the financial system operational, has since turned into a permanent juicing of the markets to keep them chugging higher.

The Fed starts to talk about tapering, and reverses course at the slightest whiff of risk.

Case in point…the Fed started to talk about tapering right before Thanksgiving. Markets fell a quick 5%, and next thing we know it’s off the table.

We’re not talking about the COVID Crash, where stocks plummeted 40% in a few short weeks. We’re talking about a normal 5% correction. They blamed the Omicron mutation, but that was just an excuse to postpone making tough decisions.

Our job as investors is to make money. So we appreciate what the Fed is doing.

And it may continue to work for a long time still. But we have to think about what happens next.

But the Fed isn’t the only one doing the heavy lifting. Tech stocks have helped tremendously this year.

Big Tech Stocks

The other market magician is the biggest-of-the-big tech stocks.

There have been increasing acronyms that represent these stocks:

  • First it was FANG. Facebook, Apple, Netflix and Google.
  • Then it became FAANG. Add Amazon to the mix.
  • Then it was FANMAG. Microsoft needs love too.
  • Now we can include Tesla and Nvidia. Who know what that will spell.

Whatever it spells, it’s yet another way the market is levitating.

We discussed the 5 largest stocks in our Strategic Growth Video Series, which you can view HERE.

To view just how much of an impact the 5 largest stocks have had this year, look at the following chart from S&P Global Research.

This chart is quite shocking.

As of December 6th, when this chart was published, the Nasdaq index was up almost 20% for the year.

Without the largest 5 stocks, the index is DOWN over 20%.

Let’s hear that again. The index goes from UP 20% to DOWN 20% by removing only 5 stocks.

(By the way, these 5 stocks are Amazon, Google, Tesla, Facebook and Nvidia.)

Jiminy Christmas, Houdini, that’s some trick.

We can interpret this two ways. And these two ways have extremely different outcomes.

On the one hand, this could be positive.

The fact that so much of the index has fallen means that a large majority of stocks have actually gone through a pretty tough stretch. Many have gone through outright bear markets when viewed individually.

Maybe these stocks are ready to begin to move higher.

That would provide excellent investment opportunities outside of these big tech stocks.

On the other hand, if these stocks do start to falter, watch out.

If these handful of stocks start to weaken, and there is NOT a rise in the majority of the other components of the index, we could start to see a market that shifts from slowly drifting higher to quickly falling.

Reality is probably somewhere in between.

If the magicians of the market stop rising, but a majority of the other stocks start to do better, we could see an environment where the overall indexes are choppy and flat, but without any major losses.

That seems like the likely outcome while the Fed remains accommodative.

So far, every little dip has been bought. The scary 5% correction that we saw a couple weeks ago really didn’t amount to anything.

So the slight of hand continues and the performance goes on.

The market Houdini’s have escaped harms way for quite some time now. But if the Fed doesn’t continue to escape, they could leave a hole that we will be able to see for generations to come.

Invest wisely!

It Came from Left Field

Confused baseball player

Last Friday, the day after Thanksgiving, the market fell almost 1000 points. What was that all about?

First off, let’s put this move in context.

Volatility Spikes

The VIX rose 54% on Friday. This was the fourth largest spike in the history of the volatility index, as shown below.

Largest 1-day increase in the volatility index (VIX) in history.

There are some interesting things that we find in this data:

  1. Surprisingly, the 3rd-largest spike happened this past January. Not pre-COVID January 2020, but this past January of 2021. (Like you, we don’t remember that either.)
  2. Three of these happened during the COVID crash (items 10, 17 and 18 in the chart above).
  3. Only 4 of these 20 spikes (20%) occurred during true bear markets. The other 80% occurred randomly during up-trends.
  4. The largest spike in VIX history happened a few years ago. It led to a 20% pullback in stocks.
  5. The 2nd largest spike happened in early 2007, nearly 8 months prior to the market top before the 2008 financial crisis.

This list tells us that the spike in the VIX last Friday was indeed historic. Let’s now look at this VIX spike on a chart, not just in a list.

The next chart looks at the VIX since just before the COVID crash.

Well, that’s pretty strange. Friday’s spike higher was both historical and barely noticeable.

On first glance, it would appear that the VIX has done this many times during the past year.

Should we be Concerned?

With this volatility, should we expect Armageddon? According to mainstream media the Omicron mutation is going to be the worst mutation so far. But they are paid to sell commercials, not provide rational guidance.

Their constant hype of selling fear appears to be backfiring. Viewership is dramatically lower, and trust in the media is at an all-time low, and rightfully so. But we digress.

Bottom line, it’s easy to “blame” some kind of news for big market declines.

But the move on Friday looked to be more technical than anything else.

The day after Thanksgiving has notoriously low volume. Not many institutional traders are at their desk all day, and a small number of large trades can cause big dislocations when volume is low.

In addition, the market hasn’t had much volatility in the past year. So in a way, it made up for lost time.

So back to the question…should we be concerned?

Maybe.

Any time these types of moves happen, the most important development is ALWAYS whether we see follow-through or not.

As of this writing, markets are up almost 2%. We didn’t see any follow through lower just one day later. That’s a positive sign.

As the week goes on, we should start to get more clarity on what the market wants to do next.

We didn’t make any moves on Friday. Those are not the types of days to act upon.

That said, we do anticipate taking action in client portfolios this week:

  1. Our monthly trend signal resets on Wednesday, and that could cause us to raise cash.
  2. Big moves lower offer the potential to realize tax losses on certain positions. We can then offset some of realized gains that have occurred this year by selling some losers and rotating into different positions to avoid wash-sale issues.

Other than that, it appears for now that the move was simply random and out of left field.

The likely scenario is that we slowly move back towards all-time highs.

However, as always, we are going to stay vigilant in managing risk. And if that means increasing cash, we will do so as our signals tell us to. But for now, the move appears to be a random event that we should probably come to expect more of in the coming months and years.

Until then, we’ll keep watching the markets for clues.

Invest wisely.

Strategic Growth – Episode 3

In this episode, we discuss the market during the 1970’s, the best performing assets during the 1970’s, the 5 largest stocks in the S&P 500, compare US vs International Stocks, and review the S&P 500 P/E Ratio vs Treasury Yields.

Charitable Giving and Donor-Advised Funds

The impulse to help others in need and to share good fortune is universal. It has never been solely the province of the very wealthy; charitable giving at all income levels, whether by donating time, money, or expertise, is a part of many people’s life plan.

When it comes to giving plans that involve donating wealth, the elements of several different dimensions – demographic trends, market performance, advances in financial services, increased need, and potential changes to the tax code – are combining to create unprecedented amounts of giving. And further, the way we give is changing.

We break down the recent data and the reasons behind the changes to philanthropy.

The Need of Last Year Resonated

According to a June 2021 study by Giving USA, American charitable giving hit $471 billion in 2020, a 3.8% increase from 2019. The largest increase in percentage terms was to local giving. Vanguard Charitable reports that homeless shelters and food pantries saw a rise of 147% in donations over 2019. Being able to help and make an impact in your community – the aphorism “charity begins at home” – clearly motivated donors.

But the Trend is Likely to Continue

However, there are many other reasons that played into giving that are likely to continue as we move forward in recovery. This will likely keep charitable dollars flowing. The more than decade-long strong performance of the equity markets means that wealth has increased dramatically. Stimulus programs that helped keep the economy moving also boosted consumer balance sheets as consumers elected to pay down debt. Confidence that the economy will recover and a strong labor market is also likely to result in more giving.

At the same time, a wealthy older generation is acting on their desire to leave a legacy of positively impacting their world. The difference with Boomers is that they are responding to younger generations’ priorities. Boomers see charitable giving as a way to involve their families, share their values, and create stronger bonds.

And finally, the likelihood that tax rates will increase and tax code changes will potentially alter existing tax-advantageous strategies is making it a priority to take advantage of the tax benefits available now by compressing a timeline for giving.

There’s an Efficient Way to Give

For many financial giving strategies, setting up a trust makes sense. Trusts avoid probate and they are very customizable. And they are not just vehicles for the extremely wealthy – there are many situations in which investors at all income levels can benefit from a trust structure. However, they are complicated legal structures with expense involved. Many investors who want who do not want a trust-based giving strategy are now turning to donor-advised funds (DAFs).

DAFs allow for donations of highly appreciated stock or other assets. The donor receives an immediate tax deduction but does not have to apportion the money to different charities right away. The money can stay in the account for years, be invested according to the donor’s wishes, and then ultimately be allocated to charity.

The National Philanthropic Trust cites data from 2015 – 2019 to underscore the increased popularity of these vehicles. Contributions to DAFs totaled $38.31 billion in 2019, up 80% since 2015. And people are increasingly allocating the money in their donor-advised funds to charities they have selected. More than $25 billion in grants to charitable organizations were made from DAFs in 2019, a 93% increase over 2015.

The Bottom Line

Increased need, a strong equity market, and the likelihood of losing tax advantages are propelling charitable giving. As the older generation makes their mark, they are including family – and not just adult family- in the process.

Safeguarding and Passing on Your Digital Assets

cryptocurrency theft concept on smart phone screen. Big red hacked message and empty wallet. Phone on a laptop computer.

Google searches for “cryptocurrency” hit all-time highs in May. A survey from CNBC found that 1 in 10 people now invest in crypto. Of that group, 65% got in the crypto market within the past year.2

As crypto becomes a more significant part of the financial picture, it’s essential to ensure that the assets are safely and appropriately stored and that you have a plan for the eventual transfer of them – but this process doesn’t work the same way as for traditional assets.

Taking Careful Inventory

One of the first steps to safeguarding your digital assets is taking inventory of what you have. With how many ways there are to purchase and store crypto, it’s easy to forget where all of them are located and since the space is still new, there isn’t really an easy way to keep track of them all.

Taking inventory looks different for everyone, but one of the most common ways is using a simple Excel or Google spreadsheet. You would want to include a few things: the name of the asset (bitcoin, ether, etc.), how much of it you own, your original purchase price(s), and where it’s located. This information will help you keep everything in order and makes the information easily accessible for when tax time rolls around.

There is software out there, such as CoinTracker, that can help keep track of your digital assets, but not every software integrates well with others. Right now, it may be easiest to keep it simple and stick to manual input until more sophisticated solutions exist.

Storing Crypto in Your (Digital) Wallet

There are two different kinds of wallets. Hot wallets (also known as ‘soft’ wallets) live online and are usually an extension in your web browser or an app. These would be brands such as MetaMask, Rainbow, or Strike.  The other kind is a cold wallet (also known as a ‘hard’ wallet). These exist offline, and are like a USB drive. A hard wallet plugs into your computer and because it’s not always connected to the internet, it’s generally considered to be more secure than a hot wallet. Some common hard wallet providers are Ledger and Trezor.

Secure your crypto in three ways; private keys, public keys and a seed phrase

Public keys

Every wallet comes with a set of private & public keys and a seed phrase. Wallet keys are a long string of random numbers and letters assigned to your wallet, and your public keys are like your home address. Just like how you would give out your address to someone if they wanted to send you a package, you give out your public address if someone wants to send you crypto.

Private keys

Your private keys are like the keys that unlock your home. You never give them out to anyone, and their primary purpose is to allow you to complete a transaction. So, if someone had both your public and private keys, they could drain your wallet of all funds.

Seed phrase

Finally, your seed phrase is a 12-word phrase generated from the private keys to make it easier to remember, and its purpose is to serve as a backup if you were to misplace or forget your wallet credentials. If you have the seed phrase but lost the keys, all the assets in that wallet can typically be restored.

Custodial wallets

With both hot and cold wallets, you’re in control of the private and public keys, giving you full access to the funds. This is important to note because the last type of wallet does not grant that same ability.

Custodial wallets are provided by exchanges, such as Gemini and Coinbase, and the key distinction between custodial wallets and non-custodial wallets is that with custodial wallets, you generally do not have access to the private keys. The exchange keeps them private, and because of this, some investors prefer not to store large amounts of crypto on their custodial wallet after purchasing.

Using a custodial wallet comes with less responsibility than a non-custodial wallet, but the tradeoff here is security. With a custodial wallet, in the event of a hack or data breach of the custodian, your crypto would be unsecured and vulnerable. With non-custodial wallets, you’re the only one who has access to the private keys and data (unless you were to give them out mistakenly). However, one positive attribute that custodial wallets hold over non-custodial wallets is that they are generally FDIC insured up to $250,000.

Whatever route you decide to take with wallets and storage, the main thing to remember is never to give out your private keys or seed phrase. Doing this can make all the cryptocurrency you hold in that wallet accessible to whoever gets ahold of them.

Planning to Transfer Assets

Suppose you’ve thought about investing in crypto or you currently own some. In that case, you may be wondering how these assets can be passed down since there are no standard legal procedures and holding crypto and moving it around looks different than the traditional finance framework.

The main issue in passing down digital assets and cryptocurrencies is the storage and transfer of the private key. Since it must be stored in a private location, it’s not recommended to write the private phrase in a will as it can become public record after death. In certain situations, the contents of safety deposit boxes may also become part of the public probate record, so storing the keys there may not work either.

So, how can you store the private key and ensure that the assets are passed on securely? Luckily, technology solutions have been built and are constantly being developed.

One of the best solutions currently available is using a multi-signature (or multi-sig) wallet. These wallets have multiple sets of keys and the wallet requires several of those signatures to complete a transaction. For example, if a wallet had 5 keys, two of them could be given to your attorney and the issuing company, and the remaining three could be held by you, your spouse, and your child. Then upon death, the assets in that wallet could be accessed by using a combination of 3 of the 5 keys. This allows for more security and helps mitigate the risk of someone inappropriately distributing or accessing the assets.

If you are holding your crypto assets in a non-custodial wallet, your estate planning may be better accomplished with a trust. This avoids probate and can allow the original owner to maintain control. And depending on the type of trust, the original owner may also set certain rules for how the assets are managed after death.

Custodial wallets (those provided by exchanges) generally don’t have trust support, meaning that the assets held in those wallets would be subject to probate. This is another reason why some investors prefer to hold their larger amounts of crypto in their private, non-custodial wallets.

The Takeaway

It’s estimated that 20% of bitcoin is lost forever due to forgotten or misplaced seed phrases or simply not keeping inventory and forgetting it was owned in the first place. As cryptocurrency and digital assets make their way into more investing conversations, the need for education and proper asset management is becoming more important.  This is because cryptocurrencies are managed from a security and estate planning aspect is different from their traditional finance counterparts.

Keeping track of your holdings, ensuring the cryptocurrency you hold is in a secure wallet, and beginning to think about estate planning solutions are a few ways you can begin safeguarding and building a plan to pass down your digital assets.

  1. Manoylov, MK. Google Search Volume for Cryptocurrency Topics Break All-Time High. The Block. May 20, 2021.
  2. Reinicke, Carmen. One in Ten People Currently Invest in Cryptocurrencies. CNBC. August 24, 2021.

This work is powered by Seven Group under the Terms of Service and may be a derivative of the original. More information can be found here. The information contained herein is intended to be used for educational purposes only and is not exhaustive.  Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return.  If applicable, historical discussions and/or opinions are not predictive of future events.  The content is presented in good faith and has been drawn from sources believed to be reliable.  The content is not intended to be legal, tax or financial advice.  Please consult a legal, tax or financial professional for information specific to your individual situation.

The Secret Downsides of Diversification

As of March 2021, Amazon had over 12 million different non-book products for sale (if you count books, it’s more than 75 million). Having an incredibly diverse product set is a vital part of Amazon’s business strategy.

Investors are often told diversification is a critical part of their investment plan. But is it really?

Taking numbers from 2019, there are approximately 4,210 equity mutual funds. The average number of stocks in each fund is about 38 for a large cap fund, and about 50 for a mid-cap fund. A broad asset allocation based on mutual funds could potentially have an investor owning hundreds of different stocks.

What happened to your portfolio in March 2020? Did broad diversification pay off?

Diversification Doesn’t Limit Losses Like People Think

There’s a saying that diversification is the “only free lunch in finance”. The premise is that a diversified portfolio will contain assets that move in different directions during periods of market turmoil.

For example, growth stocks may struggle when value stocks are doing well, as we saw earlier this year. It goes from style to asset class, sector, capitalization, and geography – all potential sources of diversification. Building a diversified portfolio is supposed to reduce risk, which will potentially increase return.

In theory, all well and good.

But what happens when there is systemic risk, as we saw during the early days of the pandemic?

Diversification can’t hold back a tsunami. Granted, black swans like 2008 or the pandemic are fortunately rare. But what isn’t rare at all are market cycles. They are predictable and regular. As the market moves through different cycles, different risks and opportunities emerge.

The problem is that asset allocations built on the principle of diversification aren’t built handle changes in the market cycle. They don’t see risk or opportunities coming, and don’t effectively react to these cycle changes.

Worse and More of it: Diversification May Limit Gains

Adding non-correlated investments to your portfolio is supposed to lower risk and increase return – but you can have too many. The result is that the risk-return profile decreases – you take more risk and get less return.

It’s called “deworsification.”

Deworsification is caused by creating a portfolio in which too many assets are correlated with each other. It can be caused by investing in multiple funds that hold many stocks, as described above. It can also be the result of combining different strategies in a portfolio. Investors need to be aware of hidden sources of over-diversification, such as target-date funds held in a 401(k).

Adding an additional asset allocation in a brokerage account can result in a portfolio that is simply duplicating efforts.

The problem here is that the portfolio isn’t just vulnerable to systemic risk – it’s also missing out on potential gains. The fear of concentrating in any one position often means investors lose out on potential sources of alpha because their asset allocation doesn’t allow for building a position or letting it run.

Said another way, assets tend to not perform the same in up markets, but perform identically in bad ones.

So having too much diversification hurts returns in good times without providing much protection in bad times.

A Different Approach

An ideal portfolio would seek sources of alpha and would be sensitive to risk – but only when risk exists in the market.

Limiting positions when the market cycle is indicating positive signals means reducing return. And risk management that reacts to changes in the market by reducing exposure to riskier assets can both protect your portfolio, but also allows for cash to be redeployed when signals turn positive again.

Creating this kind of portfolio isn’t about investing in stocks according to a static asset allocation – it’s about having rules that take the emotion out of investing.

Successful investing means you own right exposure, in the right amount, during the right point in the cycle. And when necessary, going to cash.

The Bottom Line

Investors have many options now, and investing can be deceptively easy – until markets change.

The free lunch quote above is attributed to Harry Markowitz, who developed modern portfolio theory – in 1952. There might be a better way than relying on traditional methods of portfolio management that haven’t kept pace with the realities of our investment universe.