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Thursday, September 25, 2008

Gather Assets through Segregation or Aggregation

People invest emotionally. For this reason, the way we structure our recommendations, the form, is often more important than the substance.

Have you ever noticed how many people treat their IRA money more conservatively than their regular money? Except for the tax difference, all dollars are green whether IRA or not and there is no reason to treat these funds differently. Even though the substance is the same (i.e. all the dollars are the same), investors often regard these two pots of money differently. If you have an understanding of how emotion can drive investment decisions, you can use this unfounded emotional circumstance to your advantage by having your clients and prospects segregate money into separate pots that they will treat differently. Here are some examples:

Divide to Conquer
Here’s a way to divide client assets so that they more willingly invest.
For clients desiring to avoid capital gains taxes, set up a charitable trust. Note that I always call this a “capital gains elimination trust” and explain the benefits to the client before explaining the one minor downside—of the assets placed in the trust, after calculating withdrawals and earnings, a projected 10% must be left to charity. Once those assets are segregated, you, of course, will be the manager of that portfolio. The client will be motivated to use this trust for the large tax advantages (avoidance of immediate capital gains tax plus a charitable deduction), but once the funds are segregated, they will most likely ask you “how should we put this money to work?” This is the same money, while previously commingled with their other funds, took your almost arm-breaking efforts to get them to invest. Now that it’s in a separate trust, investors are often more willing to get it working.

Another example is the irrevocable trust. If you have prospects and clients who will potentially have a taxable estate, use the $1 million lifetime exclusion now (most investors think that the estate exclusion is available only at death and have no idea that it is more beneficial to use it during life). Once the money is segregated, you will find it much easier to sell a larger life insurance policy into that trust than you did when the money was part of one big pot. If the client has agreed to segregate the funds, they most likely perceive that as funds they plan to leave to heirs. Therefore, what better opportunity than to place a life policy in this trust?

Pooling funds to gain control
Sometimes, it’s best to aggregate assets for clients that they have mentally segregated.
How many investors believe that “principal” is different than “interest.” If you look at a stack of money totaling $100, can you tell which part is interest and which is principal? I can’t. But your clients will certainly act as if they can and treat the principal sacredly (i.e. “I can’t spend my principal”) yet be willing to take their interest on a fun vacation to Las Vegas. Therefore, investors prefer principal-protecting investments over those that provide a higher total cash flow, yet appear to erode principal. The classic example is bonds at a premium. Investors will resist paying 105 for a bond that can be called in 10 years at 100 because they can lose the premium paid. Even when you show them that the premium bonds provides a higher cash return over time (because of the higher coupon), they prefer a bond purchased at par which returns 100% of principal at maturity. They willingly take the lesser opportunity to serve a notion in their head that their money comprises principal and interest and the principal must be protected at all costs.

Because of the preference to keep principal intact, it’s in the advisor's benefit to take the time and explode the principal/interest myth (and therefore open up many great opportunities to clients). You will be more effective if you can do this at a seminar or public presentation. People are better able to grasp concepts when they see someone else being irrational. At a seminar, ask any attendee to stand up, reach in the pocket and pull out the money they find. Ask them which part is principal and which is interest. No matter what they say, ask them to hold up the money for the other attendees and ask the audience if anyone in the room can tell which part of the money is principal and which is interest. Then proceed to explain how this distinction keeps them from making correct investment decisions, such as:
• The purchase of premium bonds
• The purchase of natural resource sticks/partnerships that mine and erode their asset base (yet might pay several times the original investment in cash flow over the years)
• Spending non-IRA principal before taking money in excess of minimum distributions from an IRA, which may help them pay lower taxes

Next time you make a presentation to a client or prospect and notice that they have arbitrary or irrational reasons for their actions, stop and ask yourself if they are mentally segregating or aggregating their money. If so, you now have some insight into addressing their irrationality and hopefully helping them make more profitable choices and to help you gather assets more easily.

Note that this post is not for the purpose of manipulating clients for the intention of earning commissions or fees unless the recommendations are in the clients' interest.

Post provided by Javelin Marketing