The Net Worth Trap

by: Skyler Greene

It happens so often it's ridiculous: a celebrity with mega-millions goes bankrupt.

Us non-celebrities may find this concept rather ludicrous. After all, if we had supersized fortunes under the mattress, we wouldn't go broke, would we?

Actually, we might: common people winning big lottery payouts have a chilling history of going bankrupt.

Asset Allocation: Should Net Worth Make A Difference?

If you have a larger portfolio, it can be tempting to take on more risk than the average investor. After all, you can afford to lose more, right?

Not necessarily. Look what happened to radiologist Dan Lacey, who took on excessive concentration risk by investing all his assets in one sector:

During the tech bubble, I put every cent into Cisco and other tech stocks. Within two years, I had accumulated $300,000, while I was living on about $35,000 a year. I went on vacation and came back to find that my $300,000 was worth $10,000 because the bubble had burst. So I started over at age 41.

While most scenarios won't be this extreme, Lacey's experience definitely serves as a cautionary tale.

The Universal Truth of Investing

There's only one universal truth about investing: bad things, like bubbles, do occasionally happen. While the tech bubble is the most recent one in the general stock market, who could forget the housing bubble? Or the silver bubble of '79 and '80? Or the current bubble in long-term Treasury bonds?

Protecting Your Portfolio

Plenty of different methods exist to calculate risk-adjusted returns. While such calculations can definitely help in determining asset allocations and portfolio structure, high-net-worth investors should also focus on conducting a holistic risk review on a routine basis. This applies even if (especially if) your money is managed by a professional.

Here are some things to analyze and watch out for from a "diversification" perspective:

  • Allocations to individual sectors. If you had too much money in tech in the '90s, the 2000s probably weren't pretty. If you had too much money in real estate in the 2000s, the 2010 decade probably won't be a lot of fun. Same goes for investors who were overweight financials in the mid-2000s. It's tempting to put a lot of money into precious metals right now, due to their meteoric rise, but again, the correction could be ugly. When examining your allocation to individual sectors, make sure that you don't have more in any one sector than you feel you can afford to take significant losses on.
  • Allocations to specific markets. Especially when investing outside of the United States, it becomes difficult to predict how policy changes or other unforeseeable events may affect individual markets. Thus, while Chinese investments may have done very well up to date, it's not a good idea to have 25% of your portfolio allocated to China. Better to have exposure to a wide range of emerging markets to hedge against problems in one.
  • Allocations to specific stocks. This should be obvious, but sometimes high-flying investors think they can get away with it. For example, billionaire Bruce Berkowitz had a 30%+ stake in AIG. I much prefer the Michael Dell strategy -- while he still has $3.5B invested in his namesake company Dell (DELL), his remaining $10B is invested in a diversified portfolio.
  • Allocations to specific types of stocks. This is similar to the "sectors" argument above. Changes in macroeconomic conditions often affect smaller or "riskier" companies more than more stable companies. Putting too much of your portfolio into "long shots" can cause irreparable damage in case of a "black swan" event like the financial crisis.
  • Allocations to specific institutions. As demonstrated by the Peregrine and MF Global scandals, institutions you give your money to may not always be around when you want to take it out. You probably know that the FDIC currently protects bank accounts up to $250K and the SIPC provides similar coverage for brokerage accounts. However, SIPC coverage maxes out at $500,000 per account, which is well below the net worth of many wealthy investors. Thus, consider spreading out your investments over multiple brokerages.
  • Allocations to specific institutions, part two. The Bernie Madoff scandal taught investors never to place too much of their money with one individual company, and this tactic should be followed with institutions in general. While it's unlikely that a major broker like Fidelity or Charles Schwab would be involved in such a scandal, nothing is impossible. Better to protect yourself by spreading fund or ETF investments across multiple managers.

Having a high net worth is undoubtedly a good thing, but it does come with certain headaches - one of which is adequate risk management. Whether you're a frugal saver with a large IRA or a successful small business owner, it's important to keep the above factors in mind when constructing your portfolio.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.