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| Fiduciary Focus: Modern Prudent Fiduciary Investing (Part 2) |
| by
W. Scott Simon
| 11-05-04 |
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In last month's column, I discussed the meaning of investment risk within the context of modern prudent fiduciary investing. A key point made in that discussion is that fiduciaries ordinarily have the duty to diversify a portfolio in order to reduce the portfolio's uncompensated risk. This column continues and expands upon that discussion.
Because risk is the central factor at work in financial markets, investment advisors must think consciously about it when building client portfolios. It's probable, though, that most advisors (in fact, most investors) don't give much thought to investment risk. Only after a market has decimated their portfolios do they think about risk.
To the extent that investors even think about diversification of risk, most of them engage in what I have termed "naive diversification." That is, they hold some number of investments with the objective of maximizing expected return. The problem with this approach to diversification is that it not only doesn't account for risk but can actually be quite risky. Naive diversifiers tend to have a non-portfolio mindset, thinking in terms of "bits and pieces."
Those that engage in what I have termed "rational diversification" avoid stocks that have high covariance to each other in order to reduce portfolio risk--with the added bonus of possibly increasing return. It is this notion of diversification that is discussed extensively in Restatement Commentary, not naive diversification. Rational diversifiers tend to have a portfolio mindset, thinking in terms of "the whole."
These quite different approaches to diversification of risk lead Nobel Laureate Harry Markowitz to suggest that naive diversification tends to promote "speculative" behavior, while rational diversification tends to promote "investment" behavior. A recent case in which I appeared as an expert witness shows why.
The advisor that was sued in the case invested the client's portfolio in 24 individual stocks and 18 mutual funds that were concentrated primarily in a single market sector. Because "new economy" stocks were all the rage in the late 1990s and into 2000, due to what many thought was their nearly unlimited potential, the advisor responded by investing the client's portfolio heavily in them. Nowhere in the material provided to me could I detect that the advisor had given any thought to risk or portfolio diversification.
What the advisor did was what most investors (and probably most advisors) do: It sought to identify stocks believed to offer the best odds of maximizing expected return. Talk of this kind of investing is usually avoided in polite company since much of it really amounts to little more than "chasing return." To the extent that any notion of diversification enters the picture, the usual approach is to "diversify"--yup, you guessed it--among those stocks thought (often by "cheerleading" Wall Street investment analysts) to offer the best odds of maximizing expected return. That's naive diversification.
Naive diversifiers fail to make any effort to determine the appropriate level of risk for a portfolio. In effect, they let portfolio risk levels just happen. By selecting investments with significant expected returns, naive diversifiers allow the unconscious introduction of a significant amount of "bad" risk into their portfolios.
Bad, or "uncompensated," risk is not good for portfolios because financial markets don't reward investors for retaining that kind of risk. In fact, many investors that retain relatively large amounts of uncompensated risk in their portfolios are penalized with lower returns. And that's exactly what happened to the advisor's client.
The client's portfolio collapsed in value because the advisor concentrated much of it in only one market sector that, by definition, consisted of stocks that had high "covariance" to each other. When the bad news hit, the client's stocks all bit the dust since high covariance stocks react to news in similar ways at similar times. Nor did the advisor use collars or other risk management techniques that could have mitigated damage to the client's portfolio.
The advisor's defense was that it had thoroughly invested the client's portfolio in a sufficient number of stocks and mutual funds. The advisor explained its idea of diversification this way: "Holding 30 to 45 individual securities is well regarded as a completely diversified portfolio, even in the context of having some sectors that are more representative than others in that portfolio."
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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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