Mutual Funds: Dealing with Market Downturns
Investors who ignore history are doomed to repeat it. Lessons of a BY MAUREEN NEVIN DUFFY
A TIME TO REEXAMINE Most planners we spoke with said bad markets present an opportunity to revisit an investment strategy. From a big-picture perspective, financial planners basically make assumptions and decisions based on estimates, says Bart Francis, CPA, CFP, CIMA, a planner in Boca Raton, Florida. In a bear market, he says, “we not only have the significant repricing to consider, but also changes in expectations. Aha, the new economy turns out to be the old economy—with a few extra wrinkles. We then have the opportunity to take another look at clients’ goals and assess the reasonableness of the assumptions we initially used in their planning based on new, reduced stock prices.” Angelo Ciullo, a CPA who is series 7 and series 66 securities licensed, helped his firm, Trien Rosenberg Weinberg Ciullo & Fazzari, LLC, in Morristown, New Jersey, launch its financial advisory service in the fall of 1999. Ciullo and his partners analyze their clients’ needs and design investment strategies accordingly. They began investing for clients between November 1999 and March 2000, the same month the market began to drop, and soon found themselves rebalancing their original allocations.
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“If the recommended asset allocation is, say, 60/40” stocks to bonds, says Ciullo, “and stock values slide to 40% of portfolio value, you’ve got to rebalance the bonds,” to maintain the ratio. Ciullo sold bonds to buy lower priced stocks. When the stock market started to rise, the bonds declined in value, “averaging everything out,” he says. Ciullo’s example highlights another reason to review strategy—diversification tactics may have lost their effectiveness. “The correlations get thrown out,” agrees Barbara Raasch, CPA, a partner of Ernst & Young in New York City. For example, if the strategy is to divide the client’s stock portfolio among 10 different asset classes, and one of the classes, say large cap stocks, loses 20% of its value, the investor won’t own enough of the S&P 500 (the benchmark) to stay within his or her investment policy or test for exposure. Risk assessments and other forecasts won’t be true. Most clients are oblivious to such concerns, says Stuart Zimmerman, CPA/PFS, a principal in the St. Louis-based Buckingham Asset Management and a member of BAM Advisor Services, created in 1997. Clients are more likely to ask, “Can I afford to retire now?” Or, “Can I buy that place in Florida?” he says. Many clients see a bear market as a reason to cash out, says Francis. Because of his long-term investment philosophy he typically views this as a mistake. Other clients see it as an opportunity to buy, “a kind of Kmart BlueLight special. But many companies are still overpriced based upon their price-to-earnings ratio,” he said this spring, “but when viewed in comparison to the past few years, they’re much better than they were.” OPTIONS WITH LIMITED OPTIONS Another positive of a down market is that clients who have nonqualified employee stock options can exercise them with less compensatory income. This typically requires a buy-and-hold philosophy rather than an approach that involves simply trying to cash out of in-the-money options. For holders of incentive stock options, exercising when the price is low will reduce the clients’ exposure to the alternative minimum tax. (A client who exercises incentive stock options when the stock value is low reduces the amount of tax preference adjustment items included in income for AMT purposes.) But Francis cautions the right strategy depends on the specific situation. Francis’ clients also seek his advice about when to exercise options based on their future with the company. A number of his clients received blocks of stock options that are now “under water” because the companies’ stock prices still aren’t doing well. Consequently, the client may feel there is not adequate incentive to stay with the company, let alone exercise the options.
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When clients have too much wealth tied up in a company, such as the one they work for, Francis generally advises them to diversify, but this isn’t always simple. “There are challenges to selling stock if the client is a key employee. They need to be aware of the message they are they sending to Wall Street.” Key employees may have to put the company’s welfare ahead of their own. ON THE RIGHT TRACK All of the planners we spoke to typically spend many hours talking with new clients to assess their risk tolerance and investment horizons—in other words when they expect to need to draw from their portfolios. Raasch tried her best in January 2000 to rein in one client, an adventurous young entrepreneur with a high-flying high-tech company. He had an aggressive portfolio, invested entirely in high-tech companies that yielded no annual cash flow from interest or dividends. The client had made a lot of money on the sale of his technology business two years before, and was staying on as an executive with the company. Frequent bonuses and compensation from that position allowed him to spend lavishly. Raasch had a tough time convincing him to invest in more conservative investments, such as bonds, because the 40-year old was certain his $100 million portfolio ensured he had more assets than he needed to live on, even though his portfolio was concentrated in only one industry. Even after the value of his portfolio dropped in April 2000, Raasch says he was reluctant to invest in anything other than his technology holdings because he was sure the correction was over. She did calculations based on his age, spending and appropriate return assumptions to illustrate his portfolio’s risk and return potential, as well as that of her recommended plan. “This showed him,” Raasch says, “that by selling half of his $100 million portfolio and investing in a diversified portfolio he could achieve both his short and long-term objectives with greater probability than if he continued to hold his current portfolio.” After six months of coaxing, the client sold half his tech holdings in June 2000 and reinvested the aftertax proceeds in bonds, real estate investment trusts and value-oriented and international stocks. Raasch says the international stocks have fallen a little since then but all of the other new investments have performed exceptionally well. By the beginning of 2001, Raasch says the remaining $50 million of the client’s tech holdings had dropped by 70% to $15 million. “His compensation was dropping and his company was teetering on failure.” He had to withdraw cash from the portfolio to live on because he wasn’t going to get the bonus he counted on. So Raasch recommended withdrawing interest and dividends rather than reinvesting them. “This kept him from selling off stock at a loss,” says Raasch. She points out that in a bear market, if investors sell stocks to buy bonds (because they’re generally safer) they are selling into a falling market. If clients need portfolio returns for income, Raasch recommends taking the greater proportion of the cash from the bond interest and the lesser amount from stock dividends (see the sidebar below).
IN TIMES OF TROUBLE Karen Goodfriend, a partner in Goldstein Enright Financial Advisors/Goldstein Enright Accountancy Corp., in Menlo Park, California, the heart of Silicon Valley, found herself smack in the middle of the high-tech meltdown. Goodfriend’s clients had come to the firm with portfolios heavily weighted in tech stocks, “because that’s what they knew,” she says, paraphrasing Warren Buffett. A former chairperson of the California Society of CPAs PFP committee, Goodfriend says most of the firm’s new financial advisory clients had been tax clients managing their own portfolios, made up mainly of stock options. The value of diversification became painfully obvious as the market dropped. “Many had less confidence about investing on their own than before the market drop,” she says. While clients had previously come to her for help in managing their sudden wealth, now they needed help maintaining it. Similarly, Buckingham’s Zimmerman has found the bear market good for business. “We have a financial and tax planning client who managed his own money. After the bear market reduced his wealth, he told me he’d fired himself.” Certainly, the personal aspect of investment advisory work plays a more important role in a bear market. “There’s a lot of handholding at this time,” notes Lyle Benson, CPA/PFS, president of L.K. Benson, a CPA/financial planning firm in Baltimore. “We have to determine whether their concerns are real or emotional. We’ve been proactive in contacting them, before they call us.” When making these calls, Benson says the key is to “listen to the clients and their concerns and help them put things in proper historical perspective.” One issue for his clients was taxes. Those invested in mutual funds were getting hit with high capital gains, passed on to them by funds that divested lots of holdings when the market started heading south. “It’s a disadvantage of owning mutual funds,” says Benson, “great for diversification, but this is the downside.” At Berkowitz Dick Pollack & Brant CPA LLP, in Miami, Randi Grant, CPA/PFS, CFP, a director of her firm and a member of the AICPA PFP executive committee, says, “We tell clients the only money they have invested now is long-term money.” In other words, it’s too late to sell in the down market. To avoid the compulsion to sell, she says, “don’t watch CNBC and don’t open your brokerage statement—there’s no point in it.” Grant’s clients did reasonably well with basically flat returns last year, due to the firm’s aversion to technology stocks and its conservative investment approach. “We were lagging the big 30% returns of the technology portfolios,” says Grant. “But our clients are thrilled. They love us now!”
“It’s all about managing expectations,” says E&Y’s Raasch. “If I’d told my client in January 2000 that I expected a correction instead of showing him what could happen to his income, net worth and ability to maintain his financial independence in the event of a technology industry decline, he wouldn’t have been prepared for the slump.” She addressed the client’s most immediate concerns by pointing out that he could meet his cash flow needs by withdrawing the interest and dividends the portfolio generated. The key, Raasch says, is to “reassess the client’s risk tolerance level and be sure of it. Clients with high risk tolerance often have no stomach for pain in a down market.” Even Raasch’s entrepreneur spoke with her several times about selling all of his stocks when their value dropped by more than $35 million. But with the risk management strageties Raasch put in place, she was able to convince him to “hold tight” because, even with this loss in value, he would still incur capital gains taxes and transaction costs if he sold. “Why pay income taxes to sit in cash?” At last word, her client was still hanging on. A RETURN TO NORMALCY At the time of this writing, in June 2001, the worst of the bear market may be over. But even if this is true, the long period of annual double-digit stock returns may have come to an end. Markets are likely to return to a more normal cycle, one that includes occasional declines. The more CPA/financial planners learn the lessons of the 2000 to 2001 downturn, the better prepared they will be to manage their client’s investments—and expectations—in the future.
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THE RECENT BEAR MARKET CAN TEACH SOME VALUABLE lessons to CPA/financial planners and their clients. The first sustained market decline in recent memory was a test of CPAs’ investment and client management skills. 
o prepare for the inevitable rainy day, most CPA/financial planners advise clients to diversify their portfolios, cautioning them that markets can go down just as easily as they go up. But some clients, for various reasons, don’t always follow that advice. What do you tell a client who has lost $5 million in a bear market? What of the widow watching her life savings disappear who asks, “When is it going to stop going down?” CPAs must reassure these clients and do their best to manage investment portfolios that have been mauled by a large bear. The onslaught of the 2000 bear market presented some financial planners with their first opportunity to test their skills—both investment and client management. Whether they are new to the game or seasoned pros, their experiences offer some valuable lessons. 
Against the Gods: The Remarkable Story of Risk, by Peter L. Bernstein, 1st edition, John Wiley & Sons, New York City, October 1996. 
