Diversifying a Concentrated Portfolio

In the Fall of 2010, I started a business which resulted in a larger return on investment than I anticipated.  In the middle of last year, that single asset accounted for approximately 60% of my net worth.  At that time, the Herfindahl index (a measure of concentration) of our family assets was 0.31. A well-diversified portfolio should have a Herfindahl index closer to 0.02.

We weren't comfortable having so many of our eggs in one basket.  We didn't want to sell the entire asset immediately because that would cost us a lot in taxes and slippage.  After a few weeks of research, we settled on the following plan to diversify over time.  In the last 6 months, this has brought our Herfindahl index down to 0.20 so far.

Asset Caps

The first step was to cap the maximum value of our most concentrated asset.  We used the asset's current percentage of our net worth (60%) as the initial cap.  When an asset increases in value above its cap, we sell the excess and move it into another investment.

This is similar to the time-tested strategy of portfolio rebalancing.  It makes sure that our portfolio doesn't become any more concentrated than it already is.  It also tends to sell assets when their market value is higher than normal.  If a concentrated asset drops below its cap, we do nothing.

Regular Cap Reductions

The next step is to lower the cap over time.  In the context of IPOs, there are many opinions of how quickly to sell off a single stock position.  There are even services to do it for you.  The best articles I found prefer a strategy like "sell 10% each month for 10 months."  Those articles include some fun tools for simulating how these rules would have worked in the case of various, historic IPOs.

Because our family performs these calculations in a spreadsheet, we settled on a simple linear decline where the cap drops from 60% to 1% over the next 18 months.  This makes sure that we never sell 100% of the asset.  The linear decline balances diversifying quickly against minimizing tax/slippage losses.

Wealthfront

When the above rules result in a sale, we move the proceeds into our Wealthfront account.  This makes sure that they're quickly and easily placed into a highly diversified portfolio.  Between tax loss harvesting, $0 trades, daily rebalancing and time savings, this is much more cost effective than managing a similar portfolio myself.

We could have used Betterment, which is similar.  I chose Wealthfront because they offer direct indexing (lowers taxes and fees in the long run) and because they publish thorough white papers with gory details on how and why their systems behave the way they do.