Spread Your Bets

By Daniel Kadlec

Like the quickest kid in the hunt on Easter Sunday, many investors end up with a lot of eggs in one basket. It's not really their fault. The rapid rise of stock-based compensation at work is a primary culprit--and who's going to knock programs that grant stock options and otherwise stuff employee accounts with company shares through stock-purchase, profit-sharing and 401(k) plans? The problem is that many folks end up with their retirement dreams tethered to a single stock.

Now repeat after me: No stock is bulletproof. Not GE. Not Big Blue. Not Ma Bell. Not [your company here]. Some are less vulnerable. But shifting consumer tastes and new technologies can devastate any company any time. No one understands that better than highly paid executives--unless it's the financial firms that advise them.

Through something called swap funds, also known as exchange funds, Wall Street has divined a way for some overly concentrated investors to trade one stock that has risen for a basket of stocks of equal value--avoiding any immediate capital-gains tax. A crush of financial firms, including Banker's Trust, Salomon Smith Barney, J.P. Morgan and Donaldson Lufkin Jenrette, are launching swap funds right now. They aren't entirely new. But Congress took a whack at limiting them two years ago, and they're resurfacing with a new look.

Here's how they work: investors contribute their appreciated stock to a limited partnership in exchange for a proportional interest in it. After seven years, the partnership dissolves and each partner redeems his interest "in kind." That means partners are given equal amounts of all the stocks in the fund. It's a nifty way to launder, say, 50,000 shares of General Motors into about 500 shares each of 100 different companies without having to sell and pay an immediate tax on the capital gain.

The rub is that swap funds aren't for everyone. They require that the stock be held in taxable accounts and are designed with stock-laden executives in mind, not the masses in tax-deferred retirement plans. They also require a minimum investment of $500,000 and a net worth of $1 million. It's a select crowd, for sure, and that bugs me. Diversification is a huge issue for all investors. If tax-free diversification for the rich is allowed to stand--and, frankly, even if it isn't--the time has come to ease restrictions on company-contributed shares in 401(k) plans. The average 401(k) account with employer stock contributions has 55% of its assets in the employer's stock. That's way too much. The plans should allow participants to diversify within the plan to 10% employer-stock exposure, or less.

Meanwhile, there are steps you can take. For starters, don't buy more company stock if you're getting a healthy slug of it from the boss. If you exercise stock options, diversify immediately. Remember, your most valuable asset--your career--is also tied to the health of your firm. If you're over age 55, your employer may allow you to sell some of its stock held in your 401(k), so be sure to ask. In your taxable accounts, lean toward diversified mutual funds, or individual stocks in at least six industries--and avoid the one in which you work. If you are concentrated in a single stock in a taxable account--and are not wealthy enough to join a swap fund--you'll have to pay capital-gains tax as you diversify. In most cases, that's a price worth paying.

See time.com/personal for more on diversification. E-mail Dan at kadlec@time.com See him on CNNfn Tuesday at 12:45 p.m. E.T.