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Fiduciary Focus: Case for Diversifying a Concentrated Portfolio (Part 2)

A prudent portfolio is built on broad asset classes, not industry sectors.

W. Scott Simon, 03/01/2007

In last month's column, I discussed the all-too-common situation where a large portfolio (whether involving a private family trust, an individual, or a non-profit) is concentrated in one stock or a very few stocks. I noted that investment fiduciaries cannot sit by passively and ignore the existence of this kind of risk in the portfolios for which they are responsible.

All bodies of fiduciary law--including the 1974 Employee Retirement Income Security Act (pertaining to private retirement plans such as 401(k) plans), the 1994 Uniform Prudent Investor Act (pertaining to private family trusts), the 1997 Uniform Management of Public Employee Retirement Systems Act (pertaining to public employee retirement plans), the 2006 Uniform Prudent Management of Institutional Funds Act (pertaining to non-profits such as foundations and endowments) as well as modern investment theories--require fiduciaries to take affirmative steps to diversify risk broadly as part of a prudent investment process.

While trying to minimize taxes is a worthy objective in general, that objective should never be allowed to override a prudent risk management strategy. That's why I suggested that a fiduciary just sell off a portfolio concentrated in one stock (or a relative few stocks), pay the 15% long-term capital-gains tax, then prudently and efficiently mitigate risk through broad diversification, and be done with it. That way, the fiduciary has largely eliminated the risk of a plunge in portfolio value and the possibility of losing some much larger amount due to the portfolio's poor diversification.

Now let's suppose that there's some fiduciary out there responsible for, say, a $10 million portfolio invested in just a few stocks that, gasp, would actually follow my advice to bite the bullet and fork over 15% of the value of the portfolio to the government. Now what?

Well, the first thing is to congratulate the fiduciary for having the fortitude to overcome the almost pathological aversion to paying taxes that many such fiduciaries (and their beneficiaries) have in this situation. It's critical, however, that this fiduciary not then turn around and negate its so-far prudent conduct by investing the after-tax balance of the portfolio with some investment advisor who refuses to be a fiduciary (such as, say, someone who owes fiduciary duties to the firm he or she works for, and not to clients) and, what's worse, invests the portfolio in narrow industry sectors rather than broad asset classes. Let's see why that's not a very smart way to invest.

Back to the (Fiduciary) Basics Once Again
Commentary to the Restatement 3rd of Trusts (Prudent Investor Rule) (Restatement) explains:

"Asset allocation decisions are a fundamental aspect of an investment strategy and a starting point in formulating a plan of diversification.Basic asset classifications might begin with cash equivalents, bonds, asset-backed securities, real estate, and corporate stocks, with both debt and equity categories further divided by their general risk-reward or income/growth characteristics, by the domestic, foreign, tax-exempt, or other characteristics of the issuers, and the like."

Note that the commentary uses asset class terms such as "cash equivalents" and "bonds"--not industry sector terms such as "financials," "health care," "telecommunications," or "technology" that many investment advisors use on the account statements they issue to their clients. No doubt these advisors would contend that their portfolios are "broadly" diversified because they're invested in, say, 10 or 12 different industry sectors. That contention is incorrect as a matter of investment theory and practice, as well as a matter of modern prudent investing standards.

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