Sometimes even advisors’ best clients, including those who understand asset allocation and stick to their financial plans, like to dabble in stock trading, or own a stock or some crypto, just because they want to.
If you like to invest with “fun money,” what’s the best way to handle these additional holdings outside your predetermined allocation?
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“My general approach to fun money is that if a client wants to do this, I’ll incorporate it into the overall portfolio,” says Keith Spencer, founder and financial planner at Spencer Financial Planning in Spokane, Washington. “We call this ‘play money’ in our firm.”
Here are some guidelines from financial advisors for dealing with high-risk investments and deciding whether they’re worth the stretch:
— How much to allocate outside the retirement portfolio.
— Not all fun money is the same.
— Tax considerations of fun money.
— Who manages the fun money?
— Does the additional holding fit within the portfolio?
How Much to Allocate Outside the Retirement Portfolio
A planner determines a client’s allocation based on the investor’s time horizon, risk tolerance and financial goals.
For example, a younger investor may have an allocation of 70% stocks and 30% bonds and cash. Meanwhile, her mother, who is closer to retirement, may be holding 50% stocks and 50% bonds and cash.
But what happens if either of those clients wants to add a spot Bitcoin (BTC) exchange-traded fund, or ETF, that’s not part of her allocation, just because she thinks Bitcoin is likely to rise? Or maybe add some Lululemon Athletica Inc. (ticker: LULU) stock because she likes the company’s workout gear and wants to invest?
If a client wants to add some play money in addition to their allocations, Spencer usually suggests no more than 5% to 10% of the portfolio go toward that.
“Because this money tends to be invested more aggressively, we take the play money allocation out of the stock allocation,” Spencer says. “So if a client’s recommended allocation is 60% stocks and 40% bonds and cash, but the client would like 5% in play money, we’ll allocate 55% to stocks instead.”
Not All Fun Money Is the Same
Some holdings outside a planner’s allocation for a client can function as components of the overall portfolio, but others won’t.
That determination depends on the risk levels of the securities themselves.
For example, says Jake Skelhorn, partner and wealth advisor at Spark Wealth Advisors in Jacksonville, Florida, a concentration in high-quality stocks like Apple Inc. (AAPL), while still risky, is different from a high concentration in a small biotech company awaiting Food and Drug Administration approval for its treatments.
“I usually advise no more than 10% of holdings in a stock like AAPL, as long as the client has an otherwise well-diversified portfolio that will provide a strong chance of achieving their desired outcome in the long run,” Skelhorn says.
Investors may want to limit their exposure even more if they’re holding a more speculative stock.
Tax Considerations of Fun Money
It makes a difference whether you use a qualified account, such as an individual retirement account, or a taxable account for your trades.
That’s because capital gains taxes can take a bite out of your gains. Having a plan for locating the assets can help minimize capital gains taxes.
“In general, we follow a simple, passive, long-term investing strategy with our clients,” says Jay Zigmont, founder and CEO of Childfree Wealth in Mount Juliet, Tennessee.
For those who want to dabble or play in the stock market, Zigmont sets aside about 10% for those activities.
“Usually, I like to use an IRA for their fun money so that their gambling does not impact our overall tax plan,” he says.
Who Manages the Fun Money?
Fun money comes in several flavors.
Some investors enjoy trading stocks in addition to their allocated accounts. Others have stocks they like for various reasons. Perhaps they inherited shares from a parent, or just have a company they like, or a theme, such as artificial intelligence, that they want to access through an ETF.
Sometimes, a new client comes to an advisor’s practice with securities that they have owned for years, and either doesn’t want to sell, or selling would result in a large capital gains tax if it’s held outside a qualified account.
Those investments can add risk to the portfolio beyond what the plan dictates the client should be taking.
How should investors and their advisors handle those positions?
“As financial professionals, it is important that we educate clients about the pros and cons of various investing strategies, including holding concentrated positions,” says Chris Urban, founder of Discovery Wealth Planning in McLean, Virginia.
Urban uses low-cost, broad-based index ETFs in client portfolios whenever possible.
“However, it is often the case that a new client brings in existing positions in individual stocks or bonds or some other specific holding and it makes sense, at least from a tax perspective, to hold on to these positions and perhaps wind them down over time,” Urban says.
Does the Additional Holding Fit Within the Portfolio?
If a client wants to hold a position for sentimental reasons, such as an inheritance, or just because they like the stock, Urban is generally OK with managing that holding for the client, if it’s something he’s comfortable keeping in the portfolio.
“This is typically the case if the individual holding is included in one of the ETFs we would use anyway,” he says.
However, if the holding is something he would not recommend, then Urban tries to steer the client toward managing it themselves in a separate account.
“For these kinds of holdings, aka ‘fun money,’ I am generally comfortable with clients using 1% or less of investable assets,” he says.
Not all advisors will manage holdings outside the portfolio.
“What the client does in their fun money account is up to them,” says Zigmont. “I do not provide advice on this bucket of money, and usually over time they realize that it is not as much fun to invest in the market as it is to just keep their finances simple and focus on living an amazing life.”
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