Almost every portfolio has them; stinkers, losers, former golden boys that have been knocked off their thrones, investments that beg for more good money to follow the bad. But clients often have a hard time throwing in the towel. After all, they may still come back, right?
Its not easy to wrench something out of a clients hands all the more so when selling would mean a larger tax bill. Yet holding onto these losers is not only a drain on the rest of portfolio, it also ties up money that would be better planted elsewhere.
THE PSYCHOLOGY OF LOSS
Even the most logical clients can have a hard time letting go of a bad investment because they have an emotional stake in the decision. Avoiding selling a loser is what John R. Nofsinger, professor of finance at the University of Alaska Anchorage and author of The Psychology of Investing, calls the aversion to regret.
You dont want to feel the regret of selling a loser, because if were still holding it, then we can tell ourselves that we havent let it run long enough, he explains. If we sell it, we have to realize the loss.
Emotional attachment is another reason investors cling to an investment long after it has gone sour, he says: Maybe its a stock that we inherited from our parents. Maybe it belongs to someone who worked at a company for a very long time.
Jerry Love, a CFP and CPA in Abilene, Texas, has had clients hang on too long just because they hope to prove they were right after all. Maybe it was just stock picking or something they read, he says. Theyre not fully invested in it, but its something they thought they should buy. Theyre in the category of not wanting to admit theyre wrong.
Investors who are also business owners may have an easier time letting go. They deal every day with having to make investments in their business that they thought would work out, notes Bob Phillips, managing principal at Spectrum Management Group of Indianapolis. They are better able to assess the facts and can see a bad investment and realize that theyre not going to break even.
PASSING THE BUCK
Deflecting or minimizing a clients responsibility plays a role in getting him or her to part with a bad buy. One way to do that is to pass the buck. You can reframe the situation as Its not your fault that this is a loser, Nofsinger says. That could mean blaming a fund manager, the stock picker or even the Federal Reserve. By deflecting the feeling of regret, you minimize it for the client.
Advisors can also chose a different reference point for assessing the value of an investment to get a client to stop banging his or her head against the original purchase price.
The professor provides this example of the sort of approach an advisor might take: We had a nice little profit in the last few months. That run is probably over and maybe this is a good time to get out with that short-term profit intact. This approach, he adds, can also help the client realize that the money sunk into an underperformer can work better for him elsewhere.
Another tactic: Get the client to consider the real cost of holding onto a bad investment, where getting back to the buy price doesnt mean breaking even. This is especially true for real estate. Sometimes, its just laying out the numbers, Spectrums Phillips says. By and large, people arent able to lay out the cost of carrying something and look at it logically.
To wit, in 2008, Phillips had clients who had purchased investments in resort areas like Florida and Arizona at the top of the bubble. When these plummeted in value, the clients became fixated on holding on long enough to recover their purchase price.
They didnt recognize that expenses like taxes, maintenance and property management fees can tack on another 5 to 10% to the propertys annual cost, he says.
FIXATED ON TAXES
Clients may avoid regret, but they have an even bigger aversion to a big tax bill, and that can work to an advisors advantage.
Realizing a gain on any investment even one thats taken a recent nosedive can trigger capital gains taxes. Although it depends on the investment sold, most long-term capital gains are taxed at the clients income tax rate. Exceptions include investment properties (where depreciated deductions are taxed) and collectables. Clients may also be subject to a 3.8% Medicare surcharge on their net investment income.
The good news is that losses realized on the sale of an investment can buffer an investor against taxes on their gains, says Mike Campbell, tax partner in the private client tax service group at BDO USA in San Francisco.
Under current IRS rules, clients can deduct the full amount of their losses against their capital gains. If their losses exceed their gains, they can deduct up to an additional $3,000 per year against their income, with the remainder of the loss carrying forward for use as a tax deduction in future years.
This also applies to an investment that has become worthless a speculative stake in a tech company that went bankrupt, for instance although in this case the client will need to obtain documentation of the bankruptcy.
If an investment is nearly valueless but still retains some value, the client can sell it to a third party as long as the buyer isnt related to the seller. As with a stock loss or a total write-off, the same $3,000 deduction per year applies.
With real estate, gains can be offset only with losses on investment properties. If the property in question was originally purchased as a primary or vacation home, documentation needs to be provided that it converted into a commercial property and that rents were collected.
You dont get to wake up every tax year and call it something different, especially if youve owned it for five or six years, Love laughs. If its just your lake house or your ski cabin and you dont ever really rent it out, then its a personal asset and not something you bought for investment purposes.
BITING THE BULLET
Some clients will do almost anything to avoid paying more taxes, which is a bad move because it can lead them to hold onto poor investments for much longer than they should.
A client may waste a lot of time trying to sidestep taxes, even when that will harm him in the long run, Love says. Once again, going back to the big picture can encourage a client to bite the bullet and pay the tax especially when whats being lost in taxes is less than what would be lost by continuing to hold onto an investment thats clearly past its prime.
It is important for people not to get consumed with what they can do to reduce their taxes, Love says. I would really sincerely love to have a $4 million tax bill every year. If I owed $4 million, then Im probably making north of $12 million.
Correction: The full amount of investment losses can be deducted from investment gains on a tax return. If losses exceed the gains, only $3,000 can be deducted per year from income, with the remainder of the loss subject to carry forward. An earlier version of this story stated the rules incorrectly. In addition, Question 10 in Augusts CE Quiz misstated the rules, and has been revised at fpcequiz.com.
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