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| Fiduciary Focus: Modern Prudent Fiduciary Investing (Part 3) |
| by
W. Scott Simon
| 12-15-04 |
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My column last month ended by quoting from Commentary to Section 227 of the Restatement 3rd of Trusts (Prudent Investor Rule): "Because market pricing cannot be expected to recognize and reward a particular investor's failure to diversify, a trustee's acceptance of [uncompensated] risk cannot, without more, be justified on grounds of enhancing expected return."
I observed that this snippet of Restatement Commentary brilliantly integrates two essential principles of prudent fiduciary conduct: 1) the duty ordinarily to diversify a portfolio to reduce its uncompensated risk and 2) a fiduciary's "central consideration" under the Uniform Prudent Investor Act: to make the tradeoff between a portfolio's risk and return.
To help explain this, let's examine what each part of the quoted Restatement Commentary means, beginning with: "Market pricing cannot be expected to recognize and reward a particular investor's failure to diversify."
I have explained previously that "uncompensated risk" reflects how the market price of a particular stock is impacted uniquely by economic and non-economic news. For example, the price of General Electric stock may go down as a result of the destruction of a key G.E. manufacturing plant in Ireland.
The bad news is that uncompensated risk comprises about 70% of total portfolio risk. The good news for an investor holding only G.E. stock is that some uncompensated risk can be eliminated from its portfolio if it diversifies by also holding stocks in companies that are unaffected by the destruction of G.E. manufacturing plants. (The even better good news for investors is that they can eliminate virtually all uncompensated risk from their portfolios by owning the market portfolio, but that's another story for another column.)
The fact that any investor has the ability to eliminate some uncompensated risk from his or her portfolio (or virtually all uncompensated risk by owning the market portfolio) is precisely the reason why financial markets won't reward these investors for retaining this kind of risk.
What the market is really saying to such investors is this: "Hey, dummy! If you don't have the smarts to hold the market portfolio, then all bets are off." In fact, holding a portfolio that differs in composition from the market portfolio is (by definition) riskier than the market portfolio. That's why many investors are penalized with lower returns for retaining uncompensated risk.
As a way to understand this, consider an investor that holds Best Candy Co. stock and Sugar Cane Co. stock in its portfolio. Because sugar is a critical ingredient of candy, the value of Best Candy stock decreases significantly and the value of Sugar Cane stock increases significantly when the price of sugar rises. Holding these two investments together in a portfolio generates (not surprisingly) higher return but (surprisingly!) lower risk than a portfolio of Best Candy stock--or Sugar Cane stock--and a Treasury bill.
Why, in this example, is a portfolio with two stocks less risky than a portfolio with one stock and a Treasury bill? The answer lies in the fact that financial markets are sophisticated and effective mechanisms for pricing investments. In our example, Best Candy stock and Sugar Cane stock are natural complements because the two stocks have negative or low "covariance" to each other. That is, the market price of one stock moves differently in relation to the price of the other stock when the price of sugar rises or falls.
The market "realizes" that the risk of holding only Best Candy stock (the risk being that the price of sugar will soar) can be "hedged" (i.e., offset) by also holding Sugar Cane stock since Sugar Cane stock will benefit when the price of sugar soars. As a result, the market "decides" that Best Candy stock should be priced in a way that generates a certain expected return, given its risk.
Likewise, Sugar Cane stock is priced by the market in a way that generates a certain expected return, given its risk. If Sugar Cane stock suddenly ceased to exist, the market price of Best Candy stock would plummet because new buyers of Best Candy stock would require a higher return for a stock whose risk (expressed as an increase in the price of sugar) could no longer be hedged.
By holding complementary stocks whose prices are affected in different ways by the same event (e.g., a change in the price of sugar), overall portfolio risk is reduced. This demonstrates how a portfolio can become more "efficient" by application of what I have termed "rational" diversification. Such portfolios provide "more bang for the buck."
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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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