Clients with a disproportionate focus on capital-gains taxes risk letting their portfolios become stagnant
A lot of the time, there’s wisdom in adopting a long-haul, buy-and-hold strategy; not only could it let investors capture long-term appreciation in equities, it also spares them the pain of capital-gains taxes and other transaction costs. But those who maintain a certain asset allocation for too long, particularly in taxable accounts, may face other risks.
“At the very least, asset allocations should change over time simply because the client is older and has a lower appetite for losses and less time to recover from them,” said Dr. Vinay Nair, founder and chairman of 55ip, in a piece for ThinkAdvisor. “Yet, a cursory glance of many client portfolios reveals how stagnant they have been for many years.”
According to Nair, many advisors and their clients hesitate to change a portfolio’s allocation — even to a more optimal one — because of tax implications associated with the decision, particularly after a decade-long bull run that has resulted in significant capital-gains. But considering factors such as the uncertainty of equity-bond correlations and decreased liquidity potentially affecting prices of various asset classes, the prospect of future downside risk is increasing.
“Many advisors understand this, yet because of their clients’ anxiety about the future, still struggle to convince them that transitioning their portfolios is necessary,” Nair added.
To address this, Nair suggested that advisors use technology-based optimization tools that allow transitions to a desired portfolio without incurring a tax liability. Not all portfolios will be able to transition equally well, he said, but the resulting allocations will still be superior to the status quo.
It’s also important for advisors to frame the problem not as a binary decision — to switch or not to switch — but as one of choosing a tax budget. Once a client understands the potential costs of staying put, they will likely be willing to incur a small cost — 25% of the tax burden associated with a total portfolio shift, for example. “In many portfolios, a small allowance can help shift a large portion [of the portfolio],” Nair said.
Finally, he said advisors should be careful to minimize portfolio distortion. “Selling positions with a loss and buying the entire target portfolio will often distort the desired allocation,” he said. “For example, if all the losses are from a given sector and an advisor sells only these, and they buy the overall equity exposure of the new portfolio, they will end up with a small allocation to the sector they exited.”