Change is inevitable in investment portfolios as market conditions evolve and better solutions emerge. 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. Yet, a cursory glance of many client portfolios reveals how stagnant they have been for many years. It is important to ask yourself: Are your clients' investment plans stuck in neutral?
A critical reason for this inertia is the tax implications of any transition from one portfolio to another. When one exits or sells an existing position, they are liable for taxes on any capital gains on that position, which are due in the year of the sale. This creates an immediate cost for any change in the portfolio, regardless of the economic driver of the change. The destination may indeed be a better allocation mix, or improved future downside protection, or a cheaper product mix — but these benefits are often weighed down by the ramifications of the immediate tax burden resulting in stagnant and paralyzed portfolios.
Advisors and their clients often resort to a status quo — but the costs are mounting. We are now around a decade into a bull run with increased concerns about future downside risk. We owe these concerns to a whole host of factors dominated by the uncertainty of equity-bond correlations and the risk of decreased liquidity affecting prices of various asset categories. A decade is also a long time for such a run, in which one's allocations should shift and reflect more stability and security.
Many advisors understand this, yet because of their clients' anxiety about the future, still struggle to convince them that transitioning their portfolios is necessary. This challenge is human. Behavioral finance has documented our tendency to choose a smaller-sooner reward over a larger-later reward in a manner that is not entirely rational. Today's pain often dominates tomorrow's gain.
In addition to the immediacy of the tax-related costs, there is the additional issue of uncertainty that promotes the status quo. Transition-related tax costs due today are certain. Any benefits due to a better destination are uncertain. Finally, even as the increasing costs of stagnancy are brought to a client's attention, these are offset by the increased capital gains on existing positions after a decade-long bull run in most asset classes.
In such a setting, what is an advisor to do?
Engage Optimization Tools
Dr. Vinay Nair is the founder and chairman of 
