The catastrophic losses suffered by Bear Stearns employees should serve as a wake-up call for all financial advisors. Investment portfolios intended for retirement must be adequately diversified.
While the job losses are distressing, most have found or will eventually find employment elsewhere. Replacing the losses in decimated 401(k) and ESPP plans (employee stock purchase plans) is quite another matter.
While the media's focus has been to foist blame on the greed and hubris of the firm's senior management, the real tragedy involves the majority of Bear's 14,000+ employees-support workers who owned one-third of the firm with their stock holdings but did not amass personal fortunes during the subprime mortgage bonanza. Years of soaring paper profits evaporated from employee savings plans as the company's stock plunged 80% in less than a year, culminating in a final implosion over a single hellish weekend. Lacking adequate diversity, their portfolios had little or no protection.
Bear employees now face a retirement with far less promising prospects than they did several months ago. This is especially true for older workers who face a double whammy: competing for employment with younger, typically lower-paid workers and trying to replace years of lost savings.
The tragedy at Bear is yet another example of why, as advisors, we have to make certain our clients' retirement portfolios are shielded from overconcentration in a single issue or market sector. That may sound like asset allocation 101, but in practice, getting clients to recognize what constitutes appropriate diversification can be an arduous proposition. Client resistance is often the paramount obstacle.
Client Resistance
There are a variety of reasons why clients resist diversifying their portfolios.
Many have an emotional attachment to their holdings. A sense of loyalty prompts them to overload with company stock. Those who inherit stock favored by a revered family member may feel an obligation to hang on to it. Surviving spouses may associate certain portfolio holdings with treasured memories or milestones in their marriage. In some cases, the profits from a stock may have provided seed money to start a business or funding for a child's education, and so hold a special place in the investor's heart.
Those who have been managing their own money are sometimes unwilling to admit their mistakes and sell losing stocks or rebalance their portfolios by selling big winners. Often, investors resist selling a stock because they want to avoid capital gains taxation.
Whatever the reason for the opposition, clients simply may not be amenable to taking the necessary steps to rebalance and diversify their portfolios. I've found that even when a favorite stock has dropped precipitously, some investors can't bring themselves to sell off. They rationalize that somehow the stock will eventually rebound. For retirees, this can be an exceptionally dangerous delusion.
Perception Is Not Reality
In some instances, getting clients to diversify is not a question of resistance but, rather, one of recognition. Lots of successful people are unaware of how concentrated their portfolios have become. Corporate executives or business principals who own shares in options, for example, often fail to recognize the full value of their holdings.
Consider the executive whose options control a block of 100,000 shares of company stock selling at $10 with a strike price (the option to buy the stock) of $7. Her perception is that her holdings are worth $300,000 less taxes-$3 per share differential times 100,000 shares-and indeed she did have $300,000 in net equity.
But she controlled 100,000 shares. If the stock continues to rise to say, $20 per share, it becomes a $1.3 million asset (100,000 shares times $10 gain per share, plus her existing $300,000 appreciation). Conceptually, executives don't always recognize the leverage their options provide. They don't have to buy the stock, but they control it.
So if our executive believes her company stock is going to do well, her options are the best place to keep her shares because they don't require any out-of-pocket money to purchase.