How an exchange fund enables highly efficient diversification

We regularly meet investors with highly concentrated stock positions, with numbers ranging from 25% to 95% of their net worth tied to a single stock. Most often, the stock has done incredibly well, and there are two main reasons why investors keep holding on to that massive risk in their portfolio:

1. Tax Loss Aversion: It can be very expensive to liquidate a highly appreciated position, pay the capital gains and reinvest the proceeds. This causes tax drag, which we've talked about before. It can take years for your portfolio to get back to its starting point. Naturally, investors avoid this tax realization and keep holding on to this risk.
2. Misunderstanding of Risk: There are a lot of behavioral biases we see at work here: thinking that the champagne will keep flowing, overconfidence in their assessment of a particular stock, anchoring around an arbitrary round number, or waiting to win back the losses from its previous high.

Misunderstanding of Risk

Let us start with the second one first. When it comes to a good understanding of risk, it seems that hindsight is 20/20. We've heard it from the employee who sold their CSCO stock in late 2001 when the stock was down 85% or the UBER employee who sold their stock in March 2020 when it crashed 50%.

These employees felt the champagne would keep flowing when the stocks were at all-time highs. When the market moved against them, panic set in, and these investors made emotional decisions to sell.

So, when is the right time to diversify? The answer is "as soon as possible."

Looking at the big picture, we see that three-quarters of the stocks in the Nasdaq-100 underperformed the index, measuring from the start of 2000. The likelihood that any given stock would outperform the index over a long-enough horizon is slim.

Zooming out even further, researchers found that out of 60,000+ stocks traded globally, only 1.3% of stocks drove 67% of global wealth creation over a ~30-year span (source). Most stocks eroded wealth over a long-enough horizon. Historically, even professionals have failed to outperform the index, and make the right bets. As Vanguard founder Jack Bogle once said, "Don't look for a needle in a haystack. Just buy the haystack".

Tax Loss Aversion

If diversified index investing is an obvious winner, why don't more investors switch their concentrated positions to a diversified one? The reason is loss aversion, a well-understood behavioral bias. Selling a stock to diversify means that one has to realize capital gains -- a definite loss to one's portfolio instead of an indefinite loss or gain in the future if one keeps holding on to the stock. So, they keep kicking the can down the road without acknowledging the risks in their portfolio.

Enter the Exchange Fund

Exchange Funds have long been an efficient tool for tax-efficient diversification. Investors can exchange their stocks for a diversified portfolio without triggering taxable events if they meet certain eligibility criteria and minimum holding periods.

Unfortunately, exchange funds have only been accessible to a tiny sliver of the population who accessed this product through private wealth channels. High barriers around minimums, eligibility, and fees kept out the vast majority of investors. Cache is bringing the exchange fund to a broader audience for the first time, with lower minimums, lower eligibility, and lower fees.

If you'd like to understand how an exchange fund works, we just published an extremely detailed guide. Read through it to see if it would fit you well!

Or let us know if you need help managing a concentrated stock position, which is any position over 10% of your net worth. At Cache, we have developed a product with you in mind.

Our website is at https://usecache.com.