Clients’ emotional attachments to individual stocks can be one of the largest obstacles to building a better portfolio.
“What you’re talking about is a familiarity bias,” said Don Riley, chief investment officer at Wiley Group in West Conshohocken, Pennsylvania.
The stock may have been inherited, perhaps through several generations, or the client may have amassed it as company stock.
Either way, clients may think about it differently than other holdings, Riley said.
“It’s just a different mindset,” he said. “Because they haven’t actually purchased the stock, it’s almost like it was gifted to them as a bonus, so they don’t feel as much is at stake with the risk that’s inherent in it.”
Riley said that he has to emphasize to clients how big the risk might be.
“When these positions are becoming 20%, 30%, even 40% of their overall net worth, it adds a lot more volatility to their overall portfolio,” he said.
Usually, Riley also asks clients the following question about the over-weighted stocks: “Let’s pretend you didn’t have this stock, and I gave you $400,000; would you go out and buy that same stock with it?”
The answer: “Of course they wouldn’t.”
Additionally, many clients are reluctant to sell because they fear the taxes.
Advisers employ a variety of arguments and strategies here, as well.
“I point out that it’s worth it to pay those taxes to mitigate the risk,” Riley said. “Sure, it’s nice to defer taxes, but not if it’s at the risk of an investment strategy that may cost you more in terms of downside than the actual tax dollars.”
Don’t let clients’ tax fears override their investment decisions, said Philip Luccock, a CFP and the president and founder of Financially Speaking in Greenwood Village, Colorado.
“If you need to sell something because the company is not doing well and you need to get out of it, it’s probably OK to take the gain and pay taxes on it,” he said.
Luccock explains to clients that tax on long-term capital gains is at a lower rate than ordinary income tax. And advisers will usually plan to sell off large positions over many years, which can mitigate the tax bill, especially if it keeps the client in a lower tax bracket.
Advisers can also try to offset taxable gains with losses to ease the tax burden, but even there, many think that it can cause clients to emphasize the wrong approach.
“Of course, we look at all that in the fall,” Luccock said. “But we’re not in the loss business.”
Luccock cites the example of a client who kept focusing on losses to counter a tax hit.
“After about the third call, I said, ‘I’d be happy to eliminate that taxable gain that you have, but you need to give me the OK to lose your money to offset that. If you give me enough time, I’ll lose enough money so you won’t have to pay taxes,’” Luccock said.
“That finally got through to them,” Luccock said.
This story is part of a 30-30 series on building a better portfolio.