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| > Investing > Fiduciary Focus |
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| Fiduciary Focus: Case for Diversifying a Concentrated Portfolio |
| by
W. Scott Simon
| 02-02-07 |
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Continued from page
1.
The Duty to Diversify Risk
The duty to diversify risk is so central to modern concepts of prudence that the Restatement integrates the diversification requirement into the basic text and commentary of the prudent investor rule. The very first of five "principles of prudence" identified by the Restatement is that "sound diversification is fundamental to risk management and is therefore ordinarily required of trustees." Restatement commentary notes that the duty to diversify risk is based on principles of modern portfolio theory. John H. Langbein, the Reporter for the UPIA and the Chancellor Kent professor of law and legal history at Yale University law school, explains: "One of the central findings of Modern Portfolio Theory [is] that . huge and essentially costless gains [can be obtained by] diversifying [a] portfolio thoroughly."
Now wait a minute, why is Prof. Langbein citing the gains that can be achieved through broad diversification instead of the losses that can be reduced through broad diversification? After all, isn't the whole point of diversification to reduce portfolio risk and therefore portfolio losses? While the reduction of risk is important, it's not the whole story of why modern prudent investing requires ordinarily that fiduciaries diversify broadly. It's not even the sexiest part of the story which, yes, you guessed it, involves increased return, as you'll now see.
You Are Now Entering a Third Dimension: the "Diversification Effect"
In addition to thinking about investing in the two dimensions of risk and return, I suggest that fiduciaries should also think about investing in a third dimension: what Roger Gibson calls the "diversification effect." The diversification effect results from the conscious tradeoff between portfolio risk and return that reduces risk and simultaneously increases return, thereby creating a prudently diversified portfolio.
Indeed, broad diversification serves the only dependable "free lunch" in investing: reduced risk and increased return at the same time. Only through broad diversification do fiduciaries get the double-barreled benefit of reduced loss and enhanced gain. In fact, cutting down on the volatility of a portfolio's returns (i.e., risk) not only reduces losses but actually becomes the source of enhanced returns. This counterintuitive (and thus wholly confusing) notion was explored fully in my column last April.
That column made clear that investment Nirvana is not achieved by an unruly class of track record investing, stock-picking, and market-timing kindergartners. Instead, it is achieved by broad diversification of a passively managed portfolio that reduces risk and increases return at the same time--and by the simple "eat your spinach" rules of making sure to keep portfolio costs and taxes low.
But Uncle Ferdinand Always Said to Never Sell the Xerox Stock
The problem is that many fiduciaries responsible for large portfolios (whether for private family trusts, individuals, or non-profits) concentrated in one stock or just a few stocks don't know about all this; even if they do, it just doesn't register with them. They do know one thing, however: Selling their stock is to be avoided at all costs because otherwise they'd have to, gulp, pay taxes.
One reason often cited by fiduciaries of, for example, private family trusts for not selling a concentrated stock position is that family lore and trust documents conspire to tie their hands. After all, many testators of these trusts funded them with the stock of the company that loyally employed them for years and years. The beneficiaries of the testator naturally feel duty bound to honor Uncle Ferdinand's warning so often expressed during his lifetime (and from the grave): Don't you ever sell that stock.
While it may have been wonderful that Uncle Ferdinand was employed by Xerox for 45 years (full disclosure: I've never owned Xerox stock, although it might be held in one or more of the asset class mutual funds I own) and fortunate that his purchases of company stock through those years have now mushroomed into a $100 million one-stock portfolio, does anyone really believe in this day and age that it makes sense--economic or otherwise--to keep such large (or even small, for that matter) portfolios invested in just one stock or even a few stocks? The same question applies to, for example, the portfolios of large private foundations--with many public charitable beneficiaries dependent on them to carry out their religious, charitable, scientific, educational, and other purposes--that are invested, for example, north of 50% in one single stock. It is inconceivable that any reasonable person (including state attorneys general who are responsible for policing non-profits) would conclude, based on modern notions of fiduciary investing, that such a portfolio is anywhere close to being a prudently invested portfolio.
The risk inherent in a one-stock portfolio or one composed largely of just a few stocks is just about off the charts. Enron was a huge viable company one day and the next day (relatively speaking), it was in bankruptcy. That fate also awaited Pan Am, Arthur Anderson, MCI, as well as other giant companies. Polaroid and Xerox are not the companies they once were, nor is the value of their stock. That's just a reflection of the creative destruction that continually rolls through our capitalistic system. In my own state of California, Pacific Gas & Electric (a utility often referred to as a "widows and orphans" stock) went bankrupt in the first quarter of 2001. Most of my maternal grandmother's portfolio was concentrated in PG&E stock, and she lived a comfortable life as a result. I shudder to think what would have happened to her had she lived long enough to go through that bankruptcy.
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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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