The end is nigh! Or not. Either way, here's how to prepare your clients to traverse that uncharted country beyond Jan. 1

November 12, 2012 — 7:17 AM UTC by Guest Columnist Rob Isbitts


Oh, we had heard about Cliff. We were warned about this nefarious character many months ago. We knew he was lurking and we knew he was not going to just go away. Cliff had invited himself into our lives, and unless we dealt with him, he was not going anywhere. You, the hard-working financial advisor, have probably been wondering when everyone else would notice him. That time came when the sun came up Wednesday after the election. There he was, casting his extraordinarily long and potentially costly shadow. Fiscal Cliff finally entered the national spotlight. Begrudgingly, it is time to meet him.

By now you realize I am talking about the United States’ most pressing economic issue since the 2008 crash: a combination of tax and spending events that, barring Congressional action, will occur on Jan. 1, 2013. If left unaltered, they will almost certainly cast us once more into a deep recession. Oh yes, that’s Cliff. And for those reading this who remember our kids watching Clifford the Big Red Dog in morning cartoons: Remember how huge he was compared to regular dogs? That’s about how big and bad Fiscal Cliff is compared a “regular” adjustment in the economy. See: Joe Duran tries out novel financial planning strategy on himself and his wife.

The threat of Fiscal Cliff will likely lead to some emotional moments between now and year-end, and well into next year if parts of Cliff get kicked still further down the road. Below, I’ll address how to explain the Fiscal Cliff to clients, how to plan for its arrival in full or in part, and some strategic ideas to consider in your portfolio construction taking him into consideration.

1. Explaining Cliff to clients

The best explanation I found was on the website for The Committee for a Responsible Federal Budget. They describe themselves as “a bipartisan, non-profit organization committed to educating the public about issues that have significant fiscal policy impact.” The Committee is made up of some of the nation’s leading budget experts including many of past Chairmen and Directors of the Budget Committees, the Congressional Budget Office, the Office of Management and Budget, the Government Accountability Office, and the Federal Reserve Board. That’s good enough for me.

Here is what will happen to many of your clients if a series of tax increases and government spending cuts are not amended by Congress in the next six weeks:

• Their tax rate will go up
• Their heirs will likely pay estate tax when they pass away
• They will pay higher rates on capital gains from securities transactions
• Dividends will be taxed at a much higher rate than currently
• They will be eight times more likely to pay the AMT (There’s an 8 to 1 chance they have never even heard of it… but they will owe it.)
• If they are an employer they will pay more. If they are unemployed, their benefits checks will stop sooner.
• If they are a doctor, they will have to see 40% more Medicare patients just to maintain their revenue.

2. How to plan for Cliff

The specifics of the planning are up to you. But I think that however you decide to address Cliff in your investment strategy, abandoning or badmouthing dividend investing as some will if dividend rates go up is silly. Corporate America is not dumb, and they will find a way to adapt if dividend tax rates are increased by law. After all, when Uncle Sam and U.S. consumers were using their balance sheets “like an amusement park” (very obscure Seinfeld reference), corporations were getting healthier. That is as much a reason why stocks have done so well the past few years. If dividend taxes do get to an extreme level, I’d almost expect some companies to essentially act more like REITs, which are forced to distribute nearly all of their income to shareholders. That would raise dividends to counter the tax increase. In a low-growth environment that Cliff would bring, I would expect companies, especially the higher quality ones, to be innovative and resilient. See: One-Man Think Tank: Inside the due diligence that uncovered serious questions about a REIT.

If you or your clients are uncomfortable with your level of equity exposure (due to Cliff or a very strong cyclical bull market in stocks since the second quarter of 2009), diversify it, hedge it, or both. There are many ways to do that. The one thing you should not do is to run and hide until “things look better.” When this potential crisis ends, we will have tremendous clarity on some heavy issues. That, in itself should make for more confident planning. But don’t ignore solid investment process and strategy in the name of “waiting to see” which parts of Cliff are allowed to occur on Jan. 1.

On the other hand, if you feel your investment process and strategy has some holes in it, the rest of this year should be a major call to action for you to define for yourself and your clients what you stand for. As John Mellencamp once sang, “You gotta stand for something or you’re gonna fall for anything.”

But, be aware that simply diversifying into asset classes that have a penchant for correlating with the broad stock market is not my idea of a proactive move in the battle versus Cliff. Why? Because stocks, bonds and even commodities are all susceptible to bouts of weakness. If panic ensues due to real factors, or the drama that accompanies the jacked up media coverage of Cliff, you may think you are scoring points by “moving some money around” or “rebalancing” a portfolio. But that’s a gamble when emotions run high. With the VIX volatility index starting to nudge higher, the possibility that emotions temporarily trump rational and disciplined decision-making in the short-term is real. See: 5 counterintuitive reasons why the investment vehicle of the the decade is … stocks.

Be flexible, and adapt to the new reality, if there is one. If you don’t know how and are concerned about being done in again as in 2002 and 2008, reach out for help. This industry has a very collaborative culture.

3. My suggested strategies

whether we simply get modest income and capital gains tax increases or a deluge of higher taxes and spending cuts, the strategy I recommend is the same. It’s just to a different degree, and based on your buying into a few straightforward assessments I have made:
a. Economic growth will likely be a problem for years regardless of how much of Cliff becomes reality
b. Market volatility will always move in cycles (periods of high, then low, then high again) and
c. Doing all you can to prevent major losses along the way is a central part of your investment approach.

This leads me to believe that successful investing in the coming years, starting now with Cliff around the corner, is based upon being extremely disciplined about the price you pay for any asset. Economic growth in the U.S. and in Europe is likely to muddle along and so high-growth stocks and asset classes will be tough to find. But buying the proverbial dollar for 75 cents never goes out of style.

This is clearly the most important time of our careers for managing volatility. Note that I did not say risk. Risk is a longer-term concept, and as I see it, you don’t earn the right to advise a client about risk until you have successfully managed volatility for them. What’s the difference between risk and volatility? Volatility is the movement that plays with clients’ emotions and so that’s why you have to address it continuously in your portfolio work. Risk is a long-term concept about clients having the money they need when they need it. I think risk is an overused term and volatility management is an underused concept (though you will continue to hear about it from me in my articles at RIABiz).

One scenario for Cliff is that financial disaster occurs on Jan. 1 and GDP then drops so hard that we are in a recession almost immediately. The stock and bond markets swing wildly, just begging for you to take proactive steps to limit you clients’ downside potential. Whether it’s inverse ETFs, put options, long-short strategies, or a number of other possibilities, make sure you have a good idea now of how clients should fare in a variety of positive and negative scenarios. I am suggesting that you immediately get a better handle on estimating your portfolio’s beta, and then translate that into real numbers to illustrate to your client what could potentially occur if the market went way up or way down due to Cliff or any other game. See: 4 reasons to use options — and 4 more reasons why you should think twice.

4. The upside of Cliff

There is none. OK, just kidding. But after a list like that, please forgive me for breaking the tension. I recently listened to a webcast from Greg Valliere, an outstanding source on all things Washington. Greg is chief political strategist at Potomac Research Group, a firm whose niche is “deciphering Washington for Wall Street.” Greg talks to a lot of D.C. insiders, and he believes that the AMT issue will be fixed, the spending caps will be extended, and the estate tax issue will be negotiated to a lesser evil. Most importantly for income-oriented portfolio investors, the dividend tax rate will probably rise, but nowhere near the level of one’s ordinary income rate. Why is he so confident in these assessments? Because according to Greg, no one on either side of the aisle wants them to happen. Take this information as you wish, but it seems that, as with every end of world scenario we have had before, it is not a case of our entire financial world changing. It will simply require an emotional adjustment to taking a step backwards financially. Not a leap, a step.

5. The wider perspective

Incredibly, as I searched for a precise list of what is part of the Fiscal Cliff, it literally took me 20 minutes to find a good one. Article after article in my Google search were filled with predicted outcomes and opinions. I think that at times like this, your clients don’t want you to handicap an issue as much as they want you to explain it in plain English. Then they want to know that you have not only thought about it, but that you have a plan to deal with it no matter how it pans out.

They want one other thing: To know that you are thinking about it now and not simply being reactive. To put it in a way that advisors will understand, 2010 was not the time to start contemplating how you would shield your clients’ portfolios from the ills of 2008 and early 2009.

Why is it not simpler to explain Cliff than to fill the cable news shows with fear-mongering about it? Because the scare factor would be reduced, the sensationalism would be contained and TV producers would fear that no one would watch. That’s the way it typically goes in the media world – obsessions with super-stocks (whether the company’s symbol is a popular fruit or not) and the latest government economic releases. “Breaking News” is everywhere, so to deny Cliff his several weeks in the spotlight would be, well, un-American. But that TV hype only breeds calamity. You need to be a voice of reason to counter the sensationalist tendencies of the financial media.

Once you have covered (in your own unique way) the talking points above, how do you end the discussion with your clients in a way that convinces them that you truly have some perspective on this Cliff thing? I think it is as simple as this: compare Cliff to something they have already experienced. The market meltdown of 2008-2009 took over 50% off the value of your S&P Index fund at one point. Will Cliff impact their wealth to that extent? If you passively manage the situation and wait until your client cries “uncle” and forces you to “get me out” from fear of Cliff and his aftermath, it is too late. You have lost them emotionally, and whatever you say, no matter how rationale and instructive, will be discounted by them almost entirely. However, if you educate them, show them that you knew this was coming and have been prepping for its possibility all along (have you?), then you might just experience a “light bulb” moment with them. They will remember why they hired you in the first place — to be the eyes and ears they don’t have time to have on their own, or don’t feel capable of having. You are their markets resource and interpreter, and you are all over the Cliff issue for them. See: 12 for 2012: A dozen issues you and your clients should really be focusing on this year.

And by the way, if you are not, there are still seven weeks left in the year, and there are resources to help you catch up. I hope this article helped you along in that process.

Rob Isbitts, a 26-year industry veteran, is the founder and chief investment strategist of He publishes “Investment Climate Weekly,” a new private-label newsletter that helps financial advisors deliver insightful communication to their clients each week. Sungarden provides outsourced investment strategy, research, portfolio management and communication assistance to financial advisors. Rob has written two investment books, created several portfolio strategies, and is a former chief investment officer and mutual fund manager. He offers advisory services through Dynamic Wealth Advisors and can be reached at

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