Dr. Don: A Portfolio Can't Live on Sun and Cisco Alone

A young investor's two-stock portfolio has worked well ... so far.
Author:
Publish date:

I am a 26-year-old business owner, and I currently have the portfolio below. I plan on using the money for my future children's education and for retirement. As you can see, I have only two investments, Sun Microsystems (SUNW) - Get Report and Cisco (CSCO) - Get Report. I feel pangs of guilt over whether or not I should be more diversified, but I find it incredibly difficult to argue with the returns that I have been receiving. My Sun stock started off in my taxable account as a mere $3,000 not even two years ago, and I haven't sold any of it. I bought Cisco this year, and it has been doing well. I am saving cash right now for a down payment on a house, so I won't have much new to put into the portfolio for a while. The amount of money I have in the Roth IRA doesn't seem to be enough to make an appreciable difference to my diversification. Do you think it would be smarter to sell some of the Sun stock and put it into an index fund even though I would have to pay capital gains taxes? -- D.M.

D.M.,

Too many technology investors look at investing in an index fund as a trip to the penalty box. I've been bad. I haven't diversified. I've got to sell my winners, take a capital-gains hit, and sit out the rest of the game in an index fund. Your philosophy seems to be that while no tree grows to the sun, with Sun I've got it made in the shade, but I'll feel guilty about it.

I'm not buying your premise that there's not enough in the Roth IRA account to amount to anything, so you're staying put in the two stocks. The Roth IRA is almost 25% of your portfolio. You can trade in that account without taking a tax hit. So if you're going to diversify, this account is the place to start.

In a nutshell, diversification is a good thing because it reduces the volatility associated with an individual firm's fortunes. What if one stock in your two-stock portfolio was

MP3.com

(MPPP)

?

By owning companies in different industries you reduce the risk that industry-specific economic events will derail your portfolio's return.

You don't

have

to buy an index fund to diversify. A portfolio of five or six stocks can eliminate most of the volatility associated with the individual firms. The rub is that they can't be just any five or six stocks. They have to be stocks that don't face the same corporate risks. If all of your stocks are technology stocks and the sector falls from grace, your portfolio will take a drubbing. You can do a good job of diversifying by finding stocks you want to own from different sectors in the marketplace. The table below groups U.S. industries into corporate sectors of the U.S. economy and shows the weight of that sector in the

S&P 500

index.

If you were in an index fund like the

(VFINX) - Get Report

Vanguard 500 Index, your sector weightings would match the S&P 500's, and your return would approximate that of the index. But you can diversify without going to the polar extreme of being 100% in index funds. So if you don't want to put your Roth IRA money into an index fund, start looking for companies in sectors outside technology that you think have the potential to be long-term holdings.

Now let's look at the taxable side of your portfolio. One of the beautiful things about investing in individual stocks vs. funds is that you control when you take your capital gains. You can postpone recognizing those gains indefinitely. You're a young man, investing for the college education of children yet to be born and a retirement that is decades away. Why recognize the gains now just to diversify the portfolio when you can keep that money invested and growing?

On the other hand, taking the 20% capital-gains tax hit now (assuming you sell shares you've held at least one year) can protect you from taking a larger hit later. Are you like a roulette player who, after betting red and winning three times in a row, bets red again because of how good the color has been to him? Or, do you cash in your chips, tip the croupier (Uncle Sam), and go on to the next game (investment)?

There may be a middle ground. You don't expect to be adding to your brokerage or retirement accounts in the short term. So use your taxable portfolio to continue to fund eligible contributions to your Roth IRA. Roth contributions are funded with after-tax dollars. So selling shares of stock in your taxable account to fund your Roth IRA can be cheaper than using ordinary income. As I already mentioned, gains on stock held at least a year are taxed at the 20% capital-gains rate. But assuming you make more than $26,250 annually ($43,850 if you're married and filing jointly with your wife), taxes on ordinary income are going to be at least 28%.

So don't use the excuse of saving for a down payment as a reason not to fund your Roth IRA account.

If you haven't yet contributed to a Roth IRA yet this year, and you qualify, you may be able to make two years' worth of contributions over the next five months. (Ask a tax adviser to help you with the particulars.) Between this step and reinvesting your current Roth assets, you've made a good start in diversifying this portfolio while continuing to work toward your investment goals.

Send In Your Portfolio

If you would like to submit your portfolio for a makeover, send it to portfoliorx@thestreet.com. Give us enough details -- dollar values or percentages -- so we can determine how your assets are allocated. Also, tell us a little about yourself and your investing goals, and let us know how we can contact you if we have further questions. Though we'll use only your initials publicly, please include your full name so we can verify your identity. Unfortunately, we cannot guarantee your portfolio will be selected for a makeover, nor can we promise to respond individually to everyone who submits a portfolio.

Dr. Don Taylor has been an investment professional for nearly 15 years, most recently as the treasurer for a nonprofit organization where he managed more than $300 million in assets. He is a chartered financial analyst, holds a Ph.D. in finance and has taught investment and personal finance courses at the University of Wisconsin and at Florida Atlantic University. Dr. Don's Portfolio Rx aims to provide general investing information. Under no circumstances does the information in this column represent a recommendation to buy or sell. Dr. Don welcomes your inquiries and feedback at

portfoliorx@thestreet.com.