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Investing for The Wealthy

The 3 Most Costly Investment Mistakes Every High Net Worth Individual Must Avoid


Investment mistakes for high net worth (HNW) individuals can completely erase decades of hard work and discipline. That is unacceptable from a comprehensive financial planning perspective, so it is important to identify the most catastrophic mistakes, the factors that usually cause these mistakes, and the various ways they can be manifested.
High net worth is typically defined as a household with $1 million to $5 million in assets, excluding the value of their primary residence, with “very high net worth” and “ultra high net worth” designations for wealthy households above $5 million.
The most costly investment mistakes made by HNW individuals fall into three general categories:
  • Inefficient tax planning
  • Misallocation of capital
  • Failure to consider transfer strategies

Common Characteristics in Affluent Households

To understand the risks and mistakes experienced by HNW investors, it is important to understand characteristics that are common in the group.

The households usually build wealth over time, with long-term investment strategies supported by consistently high savings, tax-conscious decisions, openness to opportunistic positions, and diversified portfolios blending traditional and non-traditional asset classes.

Most high net worth individuals have substantial private business equity ownership and tangible asset holdings such as real estate or farmland. They are generally willing to embrace increasingly sophisticated financial strategies and understand that cost of capital can be minimized with the right kinds of credit.

Investment Mistake 1: Inefficient Tax Structure

High net worth individuals operate at a different scale from the average investor. Certain elements of their plan require more attention, and taxation is a major aspect. Any earned income is generally supported with passive income from business ownership, debt interest, investment real estate cash flows, placing these investors in the top marginal tax brackets.

Stop Giving the Government Free Money They Aren’t Demanding

Excess taxation sabotages the benefits of compounding growth, and any income lost to taxation actually creates a compounding opportunity cost, which can reach staggering heights over a long time horizon. Optimal financial management takes advantage of the incentives created by the IRS to align client behavior with goals.

Strategic Capital Losses

Tax loss harvesting involves selectively realizing capital losses to offset gains or income to reduce tax liability. Portfolios require periodic rebalancing as the relative values of asset classes shift over time, requiring the sale of some positions and purchase of others.

Positions both below the cost basis and in a category that must be reduced are prime candidates for tax loss harvesting. Another strategy involves selling an investment at a loss, and replacing it with a different, but functionally similar holding, such as a correlated stock or fund share.

Capital losses can offset long-term capital gains in current or future periods, which can be extremely beneficial when real estate or private business ownership is finally liquidated. Short-term capital losses in excess of short-term capital gains can reduce a modest amount of taxable income, which can be helpful on the margins.

The Backdoor Roth

High net worth investors are often excluded from Roth IRA participation due to income caps, which represents a tremendous loss of advantageous tax treatment of retirement assets. However, missing out on opportunities to use tax-advantaged accounts is a major investment mistake.

Roth IRA contributions are made after tax, but qualifying withdrawals from these accounts can be made completely tax-free, which can be a massive break for assets that appreciate substantially. Single filers with income above $135,000 and joint filers above $199,000 are ineligible to contribute to Roth IRAs, but these people are not restricted from rolling existing retirement assets into IRAs.

401(k), SEP, Simple IRA, and profit-sharing accounts can be rolled over into IRAs, which can be converted to Roth accounts, and these account values can be substantial for owners of closely-held companies after years of substantial contributions and accumulated growth. Further, self-directed Roth IRAs can be used to hold private equity or investment real estate, opening the door to massive and legal tax avoidance for high-growth assets held until retirement.

Tax-Advantaged Products and Securities

HNW investors seeking tax liability reduction should also consider financial vehicles with preferential tax treatment. Interest from municipal bonds is exempt from federal taxation, and they are often exempt from state and local taxes from the jurisdiction in which they were issued, and this can have obvious and significant advantages for retirees living on the income generated by fixed income portfolios.

Many investors with specific estate planning needs and a desire for low-volatility, uncorrelated assets embrace permanent cash value insurance products, such as whole life. These vehicles will not produce the upside growth potential of other investments, but they provide reliable, modest gains in cash value that grow on a tax-deferred basis, are distributed on a FIFO basis, and can be structured in many cases such that distributions are never taxed. Beneficiaries usually receive proceeds of the life insurance policy tax-free.

Investment Mistake 2: Inefficient Portfolio Allocation

HNW investors have the benefit of scale that their less affluent counterparts simply lack, and it is wise to take full advantage of the opportunities afforded by such circumstances. One of the chief capabilities enabled by scale is a deep level of diversification that can lessen correlation and unlock success in any economic situation aside from total global meltdown, at which point there might be other, more pertinent concerns.

Over-exposure to a single company, sector, or strategy can be a catastrophic investment mistake with dire consequences for affluent investors.

Why You Should Own Everything

Diversification is a commonly touted investment principle that dominates portfolio theory, even across competing ideologies. Too often, this principle is understood as owning a large variety of stocks and bonds in a securities portfolio, but that narrow approach silently violates its own central thesis.

Stock and bond markets might operate independently, but they are still connected nodes within the global capital market. As such, fund flows across these classes are related, and correlation exists across most constituents of even the most diversified securities portfolio. Any financial plan reliant on the stock market to remain stable was designed to fail under the very circumstances that eventually came to fruition.

Consider Alternative Asset Classes

High net worth individuals should probably hold a substantial amount of traditional securities of all sizes from around the globe, but diversification should extend beyond those asset classes.

Real estate, commodity production interests, passive business ownership, derivative instruments, insurance products, private debt placements, hedge funds, funds of funds, and venture capital are all viable options, depending on personality, goals and need.

Proper deployment of alternative classes can ensure that capital is always sourced from the lowest-cost source, and that maximum flexibility and control provide the investor with mastery over their own financial well-being.

Hedge funds, options, and derivatives can be particularly useful for thriving in adverse market conditions, with strategies specifically designed to deliver strong returns when other asset classes are suffering.

Don’t Rely Solely on What Got You Here

The cautionary tales of bankrupt former billionaires often focus on simple mismanagement or unsustainably lavish spending, but the more mundane tumbles from glory can be more instructive for responsible HNW investors.

Many of the greatest wealth creators amassed their fortunes through the founding and stewardship of one (or a small handful) of hugely successful companies. There is no more powerful, albeit risky, wealth creation tool than closely held business equity. There are numerous instances in which individual fortunes were lost when major companies failed, decimating portfolios with heavy exposure to those firms. Founders often have massive concentration in their own creations, be it due to misplaced optimism or functional illiquidity.

Whenever possible, HNW households should avoid over-exposure to any business that has helped them attain transformational wealth. The economy is built on competition among firms and consumers, and an unexpected market shift is always lurking around the corner to doom the Blockbusters and Blackberries of the world.

Investment Mistake 3: Poor Transfer Planning

HNW families are often very charitable, and large fortunes are unlikely to be spent entirely by the creators of that wealth, so estate planning and transfer management are especially important for investors hoping to avoid wealth erosion while achieving legacy goals.

Financial planning is ultimately tasked with driving balanced growth and stability, and it is a significant investment mistake to allocate cash flows and assets without considering important wealth transfer goals.

Gifting and Charity

Gifts are taxable transfers, but the first $15,000 given by either of the married couple to a recipient is exempt from taxation. These exemptions apply to an unlimited number of recipients.

Transfers to friends and family members should be structured with this in mind. Investments should be planned and deployed to fit these expected transfers.

Estate Planning Strategies and Vehicles

Estate planning is another area of financial planning in which many HNW investors squander funds unnecessarily. Federal estate taxes exclude transfers under $11.2 million, but each state has their own laws pertaining to estate taxation. For these reasons, many investors explore trusts and permanent life insurance vehicles that can circumvent estate taxation, and the establishment of such strategies often impacts overall investment portfolio allocations.

Rising life expectancy is creating unprecedented burdens for the health care system, and expense planning for care in twilight years is a major concern among many affluent families. Long term care (LTC) expenses can run up to $10,000 per month, and extended stays in LTC programs can quickly wipe out assets that have been accumulated through hard work and diligent investing over numerous decades. Medicaid planning trusts and long term care insurance are two popular strategies designed to overcome the risks presented by the health care associated with longevity.

Design a Strong Investment Portfolio

High net worth investors understand that money is a tool. Hence, it’s critical to be able to create a robust plan designed to mitigate these mistakes thereby minimizing capital and opportunity cost while expecting more returns.


Linden Thomas and Company and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

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