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| Fiduciary Focus: Modern Prudent Fiduciary Investing and Investment Risk |
| by
W. Scott Simon
| 10-05-04 |
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Last month in this column, I made the (counterintuitive) point that the better way for advisors to increase portfolio wealth is to concentrate more on managing risk and less on trying to score big in the random game of identifying investment winners through stock-picking and market-timing.
Because I have been emphasizing return, I thought it might be worthwhile to spend some time discussing investment risk if for no other reason than that a fiduciary's "central consideration" under the Uniform Prudent Investor Act is to make tradeoffs between portfolio risk and return.
The Prefatory Note to the Act and the Restatement 3rd of Trusts (Prudent Investor Rule) emphasize the pervasive influence that Modern Portfolio Theory has had on prudent fiduciary investing. One of the essential tenets of Modern Portfolio Theory is that portfolio risk should be minimized given a certain level of expected portfolio return.
Any discussion of investment risk within the context of modern prudent fiduciary investing must begin with the fundamental observation made by the father of Modern Portfolio Theory, Nobel Laureate Harry Markowitz: Selections of portfolio investments involve making decisions under uncertainty.
This leads to the conclusion that risk (i.e., uncertainty) is the central factor at work in financial markets. Investment advisors must, therefore, think consciously about risk as they go about building portfolios for their clients.
Naive Diversification vs. Rational Diversification
Modern Portfolio Theory originated in the mind of Markowitz one day in 1950 as he was reading a well-known investment book called The Theory of Investment Value by John Burr Williams.
Williams maintained that investors should seek to maximize the expected returns of their portfolios. In Williams' view, diversification was equivalent to holding a large number of stocks that are anticipated to maximize expected return. It struck the 23-year-old Markowitz that Williams' approach was one-dimensional. Seeking only to maximize return didn't take into account the element of risk.
Indeed, Markowitz thought that Williams' notion of diversification--holding a large number of stocks with the objective of maximizing expected return--not only didn't account for risk but could actually be quite risky. Markowitz concluded that since Williams' approach didn't take risk into account, he failed to imply the desirability of diversification.
Williams seeks to diversify among stocks that are expected to maximize expected return. The "riskiness" of Williams' notion of diversification arises from the fact that stocks with maximum expected return often have high covariance to each other. ("Covariance" describes how the market prices of investments move relative to each other in response to new information.)
An investor following Williams' approach to diversification might have, for example, in 1999 held many high tech stocks in its portfolio--stocks with maximum expected return. The ensuing collapse in value of many of these stocks readily demonstrates the risk that Markowitz identified in Williams' approach to diversification. In my book, The Prudent Investor Act: A Guide to Understanding, I have termed Williams' notion of diversification as "naive diversification."
Markowitz's notion of diversification is radically different from that of Williams'. Markowitz seeks to avoid stocks that have high covariance to each other in order to reduce portfolio risk (with the added bonus of possibly increasing return). Markowitz suggests that his notion of diversification tends to promote "investment" behavior, while Williams' notion tends to promote "speculative" behavior. In my book, I have termed Markowitz's notion of diversification as "rational diversification."
Total Portfolio Risk: Compensated Risk and Uncompensated Risk
According to Modern Portfolio Theory, risk can be managed through diversification. (Risk can also be managed through other techniques of risk management such as stop-loss orders and collars.) Section 3 of the Uniform Prudent Investor Act reads: "A trustee shall diversify the investments of the trust unless the trustee reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying."
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| W. Scott Simon is an expert on the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule). He is the author of two books, one of which, The Prudent Investor Act: A Guide to Understanding is the definitive work on modern prudent fiduciary investing. Simon provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. He is a member of the State Bar of California, a Certified Financial Planner, and an Accredited Investment Fiduciary Analyst. Simon's certification as an AIFA qualifies him to conduct independent fiduciary reviews for those concerned about their responsibilities investing the assets of endowments and foundations, ERISA retirement plans, private family trusts, public employee retirement plans as well as high net worth individuals. For more information about Simon, please visitPrudent Investor Advisors, or you can e-mail him at wssimon@prudentllc.com The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar. |
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