- Anchoring: Analysts often underreact to new information when revising their forecasts; investors also tend to assume the current prices are about right.
- Overconfidence: Analysts and investors alike can be overly optimistic about past winners and overly pessimistic about past losers. Even when evidence shows that investors cannot beat the market on a systematic basis, they often believe they can.
I can just hear your clients saying, "I promise to diversify my portfolio once the stock gets back to where it was in June," or "I am sure that the stock is still rising, I do not want to diversify now."
We all know the damage that can occur from concentrated positions, but do your clients? If they are close to retirement and have already forgotten the turbulent years earlier in this decade, reminders of Enron and WorldCom could snap them back to reality. Whether it is the current fascination with the ever-surging Google or the client's employer's stock, too much of a good thing is not a good thing.
So how do you protect clients from their emotional selves? If clients are reluctant to diversify with a simple reminder, further conversations may be required.
The first thing you may want to discuss is the concept of event risk. The simplest way to define event risk for clients is to use the phrase, "stuff happens." Time and time again, sectors and companies believed to be impregnable have proven anything but. Just look at the chart on the next page of certain companies' stock performance from 2006. It shows that a significant drop in value can occur suddenly--even to stocks considered as blue chips.
For those clients who are reluctant to diversify at least a portion of their concentrated positions, we must get them to think about the probability of an event risk. Their own estimations of such risks would most likely be much lower than actuality. Many research studies show that people are not good at determining probabilities because we make many assumptions and shortcuts in judgment to arrive at our answers.
Therefore, we must get clients to focus on the downside risk and how it could affect their long-term goals. Your clients must come to the conclusions that they most likely are putting important goals in danger by holding onto concentrated positions.
Out in the Open
Here are some suggested questions to start the conversation with reluctant clients:
- What are your spending needs, now and for the future?
- How would a drop in the value of your largest holding affect your ability to meet short-term needs, educate a child, start a business, and retire comfortably?
- Do you have the time or resources to recover from such an event?
- Do you have enough liquidity to take advantage of the next opportunity when it presents itself?
- What does this stock represent to you?
- What is your short-term and long-term view of the stock?
- Might there be a better way to maximize returns with less risk?
Once you have had this initial conversation with your clients--and they show interest in discussing better ways to maximize their returns with less risk--the next step is to present some solutions. Keep in mind that typically there is no one-solution answer, and no right or wrong strategies, either. It depends on the clients' investment views and holdings, plus their personal and financial goals.
In fact, a unique combination of strategies is often employed.
A Taxing Issue
In many instances, selling the stock and paying the tax could be the best and simplest strategy. However, many investors are reluctant to trigger large embedded capital gains.
While no one wants to pay taxes, you might want to ask yourself, "Are my clients being rational about their utter disgust in paying taxes?" Too many clients confuse deferral with elimination or avoidance.
Not paying taxes may actually be an excuse for an emotional attachment to one stock or perhaps other emotional issues based on fear or greed. Choosing between a diversification strategy and an outright sale is often less about taxes than many investors think. In the end, both a direct sale and a diversification strategy will subject an investor to capital gains taxes. The only difference is when the taxes are due. So as a question of timing, does it make sense to diversify the portfolio now?
If your client is adamant about not wanting to sell a stock, you may want to further explore his penchant for risk. What is your client's viewpoint regarding the risk of higher long-term capital gains tax rates in the future? This is not something to be dismissed lightly. There are no guarantees that today's relatively low capital gains tax rates will remain at the same level in the years to come. Looking at the current uncertain economic environment, where long-term capital gains rates are at cyclically low levels and our federal budget deficit is not, a case may be made for the government implementing substantial spending cuts or tax increases in the future. Given the uncertainty of the markets as well as the federal government's fiscal plans, seeking to delay a tax payment may work out to an investor's disadvantage.
One suggestion for determining a client's current financial situation is to arrange a meeting with the client and her tax accountant to discuss their outlook on future tax rates. You could also request your client's tax returns to uncover wealth management opportunities and ways to identify concentrated positions. (See the discussion on mining a tax return in the article "Eureka" in Investment Advisor, October 2006.) A joint meeting with your clients and their accountants would be a great way to show how you are the client's true "quarterback."
A Matter of Trusts
Before closing the books on concentrated positions, there is one more area that may not come to your or the client's mind quickly: trusts.
You won't want to limit your conversation only to the assets a client holds outright. You will want to broaden the discussion to assets the client may have held in trusts. Any trust your client may be affiliated with is an area to explore. For example, as long as there are no restrictive provisions in a trust's governing instrument and applicable law allows, the use of investment strategies involving derivative instruments in trusts falls within the prudent investor principles. These principles do not specifically address derivatives, but provide that nothing is, per se, prudent or imprudent. What is required of a trustee is to pursue an overall investment strategy that will enable the trustee to make appropriate present and future distributions to, or for the benefit of, the beneficiaries in accordance with risk and return objectives reasonably suited to the entire portfolio.
The concentrated position conversation may be an old one, but it remains a good one. Especially after this summer's events, clients may be more open to revisiting the conversation. It's not wrong to choose to remain concentrated, but it is vital for clients to understand the implications of that decision. While the financial and psychological rewards of a concentrated asset can be immense, so too can be the risks.
Susan L. Hirshman, CFP, CPA, CFA, CLU, is a managing director for JPMorgan Asset Management in New York. In that position, she develops strategies to provide wealth solutions to the affluent market. She can be reached at firstname.lastname@example.org.