(As printed in Worth Magazine: February-March 2015 Issue)

Financial decisions are often guided by a deceptively simple framework: maximize return for the amount of risk undertaken. This is a sensible principle and usually leads to good decision-making, but not always. A “smart” decision made in isolation does not continue to exist in isolation after you make it. Rather, it becomes part of a box of financial decisions and choices you’ve made previously. If you can’t (or don’t) see the forest for the trees, your complete financial picture may be unnecessarily exposed or sub-optimally coordinated, perhaps without your even realizing it.

Take a hypothetical high-earning business owner who runs an executive-recruiting firm. She’s in her mid-40s, with a primary home in San Francisco, a vacation home in Hawaii and a lot of money tied up in her business. Come high tide, with cash rolling in from her firm, she may be inclined to put excess cash flow to work in a high risk/equity-oriented investment portfolio. After all, with her time horizon long and her earnings high, why not hit the gas in the portfolio and, presumably, earn higher rates of return along the road to some future retirement?

Well, maybe, but first imagine what low tide might look like: another financial crisis, a messy Eurozone break-up or an unexpectedly rapid rise in interest rates. In such environments, we might expect the private sector to tighten its proverbial belt, with severe consequences to cyclical industries like executive placement. If our business owner’s revenue starts to fall short of payroll and debt payments, she will need a cash infusion. And, if credit markets are tight, and her real estate equity, once bountiful, is now thin, she may find it difficult to get a loan. Lacking a better option, she may turn to her investment portfolio for liquidity, only to find that her stocks have fallen, just like everything else.

The point is that the respective performances of our hypothetical investor’s business, real estate and investment portfolio are all connected and move in correlated patterns. Positioned carelessly, the investor is potentially left unnecessarily exposed to a particular event or market environment. While owning a meaningful allocation to high-quality, low-yielding bonds can be a disappointing experience when stocks, real estate and other risk assets are headed to the stratosphere, they can prove invaluable when things are headed in the opposite direction. If history is any lesson, the music can stop when you least expect it, and it’s therefore wise to have some safeguards to help buffer the storm.

The correlation concept applies more broadly to planning issues as well. In the world of insurance, we hope to lose our premium payments and never experience a catastrophe that destroys our house or takes our life. It makes sense to “lose money” so long as we don’t risk losing a lot of it. In the world of tax, it can make sense to stomach a tax bill to reduce a concentrated stock exposure or convert some pre-tax IRA assets to a tax-free Roth, even if the payback is no slam dunk. Predicting the future is a loser’s game, making asset and tax diversification smart components of a well-conceived plan.

The broader observation is that there are countless choices and opportunities along life’s journey, each with its own varying individual significance, that weave together within a larger framework. Through this lens, it’s important to be mindful of investment and financial planning correlations that can help navigate through the unexpected and the unanticipated. Often, the prudent decision is not necessarily the most profitable. Leaving upside on the table can be a sensible decision, particularly when it means protecting your stack.

Filed under: Wealth Management

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