When a Simple Portfolio Isn't Enough (EP.272)

0:02Peter:We all need to make smart decisions with our money. The Long-Term Investor Podcast shows you how by distilling complex financial matters into easily digestible lessons. And now, here's your host, Chief Investment Officer at PlanCorp and the author of Making Money Simple, Peter Lazaroff. I had two conversations this week with listeners who'd built meaningful wealth and believe strongly in keeping their investments simple, but both were dealing with a problem that a basic portfolio could not completely solve. One owned a concentrated position he wanted to diversify. The other knew a large taxable gain was coming and wanted to know whether there was anything he could do to soften the impact.

0:46Neither was eager to add another strategy, and they were cautious about investing in something they could not personally explain and skeptical of sophisticated investments that sound clever but turn out to be expensive gimmicks. I share that instinct. I mean, ask me whether I prefer simple or complex, and I will choose simple every time. But the goal is not to own the simplest portfolio imaginable. In my opinion, it's to use the simplest portfolio capable of solving the problems you actually have. Simple investing has gained a lot of traction since the great financial crisis, and for good reason.

1:23Index funds, rules-based strategies, and better technology have made broad diversification inexpensive and easy. In a previous episode, I argued that basic market exposure has become cheap and standardized, and that's true, but it is not the same as saying every investor's financial problems have become simple. But something changes after you accumulate meaningful wealth. Your portfolio may look simple while your financial life becomes more complicated. You may have company stock with a low basis, a business sale approaching, a large capital gain coming, or decisions that interact across your investments, taxes, and estate plan.

2:05Meanwhile, the same technology that made simple portfolios cheaper has also made specialized strategies less expensive and more accessible. One of the four steps in the decision framework in my new book, The Perfect Portfolio, asks, does this introduce unnecessary complexity? The key word is unnecessary. Complexity is not automatically disqualifying. It becomes a problem when it adds costs, risks, or moving parts without solving something important. The simple solution should always get the first look. A more complex strategy carries the burden of proof. It needs to solve a real problem, provide enough potential value after costs and risk, and fit with the rest of the plan.

2:52So let's imagine someone who owns$3 million of one stock with a cost basis of$300 ,000. The simplest answer is to sell it, whether that's all at once or spread out sales over some period of time and realize that$2.7 million gain, pay the tax, and reinvest in a diversified portfolio. And you might be surprised, but that can often be the right answer, particularly if you believe the individual stocks will tend to trail the broad market over time because after so many years, there's a break even rate between the tax bill and relative performance. But with a gain that large, I do think it's reasonable to compare it with other possibilities.

3:35So when I think of these conversations that I had last week with two of the listeners, the first group of strategies I discussed involved creating capital losses to offset gains. A separately managed account, sometimes described as direct indexing, owns the individual stocks in an index rather than in a single fund, which creates more opportunities to tax-loss harvest. Now, when we began using these strategies at Plaincorp in 2017, the added costs limited when they made sense. But today, many of the SMA strategies we consider don't cost much more than a rules-based ETF. Long-short tax-managed accounts take the idea further.

4:14Basically, they use leverage to create long and short positions that may create more opportunities to realize capital losses, all while maintaining broad market exposure. Now, that adds real complexity, along with additional costs, tracking differences, shorting and leverage. But for someone who knows a major taxable gain is coming, those tradeoffs may deserve consideration. This is a topic I could go into a lot more detail on, but I will save the mechanics for a future episode. The second group of strategies that was discussed between me and these listeners last week was diversifying a concentrated position without immediately selling all of it.

4:54An exchange fund is one option that allows someone to contribute concentrated stock to a pooled portfolio and eventually receive diversified holdings back, but it commonly involves a seven-year commitment and K-1 tax reporting. And in both conversations, an exchange fund looked potentially useful, but there just wasn't enough capacity in the vehicle that we were comfortable recommending. So a strategy's existence, I think this is a good example, does not mean a suitable implementation is always available. And I think this couldn't be more true today with something like a Section 351 exchange. And depending on the holdings, a Section 351 exchange may allow a portfolio of appreciated securities to be contributed to a newly created ETF without triggering an immediate taxable sale.

5:41But the holdings must qualify, diversification rules must be satisfied, and not every 351 offering is equally attractive. Tradable options provide another possible path. A collar can limit the downside of a stock while also limiting some upside. So if you pair a costless collar, which is buying a put and selling a call, with a synthetic exposure, which this is gonna sound confusing, but selling a put and buying a call on some broad market index, then you can have broader market exposure in exchange, in effect, for that individual stock position. Now, that sounds like a lot, and that is partly the point.

6:21Each approach that I'm talking about here solves the diversification problem differently, but each comes with a different combination of taxes, costs, liquidity, upside, and implementation risk. The right comparison is not which one sounds most sophisticated. It's how each one stacks up against simply selling the stock, paying the tax, and diversifying. There was one other group of strategies that I found myself discussing with these two individuals, and it didn't have as much to do with investing as much as it did estate planning, and that's with a grantor-retained annuity trust, or GRAT. This strategy came up in one of my conversations as a really good example of complexity potentially creating tremendous value because when it's structured and administered correctly, a grant can allow future appreciation to pass to beneficiaries very tax efficiently.

7:14Now, the legal documents, the asset selection, the tax rules, and the administration are complicated, but something can be complicated to build and manage without making your real life feel complicated. The example I always find myself giving is with a traditional wristwatch. you don't have to know how the insides of a watch works to know how to tell time. Now, when it comes to investing, I do think you should understand what the strategy is intended to accomplish and its major trade-offs and who is responsible for making it work. But complex strategies that require experience and due diligence are not necessarily a bar that just says automatic no.

7:54Now, of course, complexity is not automatically valuable. I think we all would probably agree with that. I mean, sometimes it can create higher fees or lockups, K-1s, leverage, tracking error, implementation risk, or just in general, more opportunities for something to go wrong. It also can hide bad economics just as easily as it can solve a real problem. So I think that's why if you're going to go down the path of a more complex strategy, experience and due diligence really do matter. not every advisor has experience evaluating or implementing these strategies. Hearing the name of one and knowing kind of how it works is a lot different from knowing who is a good fit, which providers to consider, and how it interacts with the tax and estate plan and actually when the simple answer is better.

8:44And as you might suspect I would believe, this is also where professional management may earn its fee. Paying someone merely to assemble low-cost funds is one thing, but paying someone to identify an opportunity, compare it with the simple baseline, evaluate providers, coordinate the moving pieces, and recognize when to walk away is a different service. The two listeners I spoke with last week didn't leave the conversation eager to add complexity everywhere. They remained cautious, but they could see why these strategies deserve consideration. And that to me was the right outcome. In fact, I devote an entire bonus chapter of the perfect portfolio to tax-efficient diversification strategies just like these that I quickly mentioned today.

9:31Simplicity is a virtue, but when it becomes an ideology, it can prevent you from solving the problems that matter most. So start with the simple answer, then make complexity earn its place because sometimes it does. As always, thanks for listening. And until next time, to long-term investing.

9:51Peter:Thanks for listening to the Long-Term Investor podcast. To access free financial resources and submit questions to be answered on the show, visit thelongterminvestor.com. Peter Lazaroff is an employee of PlanCorp and BrightPlan. All opinions expressed by Peter and any podcast guests are solely their own opinions and do not reflect the opinions of PlanCorp or BrightPlan. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of PlanCorp and BrightPlan may maintain positions in the securities discussed in this podcast.