Too Much of a Good Thing

A rubber band stretched to its limits and then let go will always snap back. Unfortunately, the markets are not as predictable as rubber bands. As of this writing, we are seeing some, but not all, areas of the market “snap back” from their summer swoon. Sadly, a snapback is often accompanied by two irrational investment behaviors–anchoringand overconfidence. These behaviors are especially prevalent when discussing diversifying a concentrated position with your clients. We discussed these irrational investment behaviors the May 2006 issue, but here is a quick recap:

• 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.”

Resisting Change

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.