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Fiduciary Focus: Case for Diversifying a Concentrated Portfolio

Excuses don't wash for fiduciaries who ignore the risks of a concentrated portfolio. 

W. Scott Simon, 02/02/2007

I have encountered over the years a number of situations where a large portfolio was concentrated in one stock or a very few stocks. These situations involved the portfolios of private family trusts, individuals, or non-profits. Some of the trustees responsible for investing and managing the portfolios were new to the job and others had been at it for a while. But all these trustees (and most of their beneficiaries) had one thing in common: an almost pathological aversion to paying taxes. That is, they didn't want to pay the taxes that would come due upon sale of a concentrated stock position in a portfolio. Let's explore why such avoidance may not always be such a good idea.

Back to the (Fiduciary) Basics
The "central consideration" of every investment fiduciary under the Uniform Prudent Investor Act (UPIA) is to determine the tradeoff between the risk and return of the portfolio for which it is responsible. It's problematic whether many fiduciaries are even aware of this paramount duty, much less carry it out. Instead, fiduciaries (indeed, many non-fiduciary investors) tend to get all hot and bothered about the return side of the risk-return tradeoff by either bringing up the past or peering into the future.

The Overwhelming Focus on the Return Side of the Tradeoff
Such fiduciaries bring up the past by looking at the track records of particular investments. "Track record investing" occurs when an investor identifies some investment such as a mutual fund with an outstanding track record and invests in it because the investor thinks that its historical performance--that is, its track record--will continue into the future. When fiduciaries become track record investors, they forget the sensible (and true) warning issued by the Securities and Exchange Commission: Past performance is no guarantee of future results. One good reason why this warning is all too true are the findings of virtually every reputable study of mutual fund performance over the last 40 years, which show that there's no reliable way to predict when--or which or even if--winners from the past will win again in the future.

Another problem with track record investing is that it doesn't do any good to rave about an investment with a marvelous track record unless one had been invested in the product that generated it. Those prattling on about a winning investment from the past who didn't hold it during that period are nothing more than, well, prattlers. Many others that decide to actually take the plunge and invest on the basis of track records then get to experience the often perverse tendency of superior track records to be followed by inferior track records. They zigged when they should have zagged; or maybe they zagged when they should have zigged, I forget which.

Other fiduciaries aren't content to bring up the past but instead want to peer into the future. They listen to the siren songs of stock-picking and market-timing investment advisors who are like a class of kindergarteners jumping up and down waving their hands, yelling "Pick me, pick me, I know the answer." A belief in stock-picking and market-timing is the belief that, to be successful in maximizing investment performance, an investor must be able to "see" into the future or find a "skillful" investment advisor that can. Fiduciaries--many of whom should (and do) know better--succumb to this fundamentally goofy idea that it's possible to predict which particular investment advisor will be able to predict which particular mutual fund, money manager, individual stock or bond, or asset class will turn out to be superior--or inferior.

Fiduciaries that engage in track record investing, stock-picking, or market-timing are guilty of a one-dimensional focus on return. To make matters worse, they have no control over the returns of investment track records because they're past, and they have no control over future investment returns because they're random variables subject to unpredictable uncertainty. Fiduciaries placing an undue emphasis on return, of course, also violate their "central consideration" under the UPIA: determine the tradeoff between return and risk in a portfolio. Perhaps more fundamentally, those focusing on return only--without taking risk into consideration--are nothing more than rank speculators not investors. No less an eminence than the father of modern portfolio theory, Nobel laureate Harry Markowitz, spotted this as a 23-year-old over a half-century ago. If you get nothing else out of this month's column, remember that investment fiduciaries--who are responsible for other people's money--cannot be speculators.

The Underwhelming Focus on the Risk Side of the Tradeoff
Returns, no doubt, are exciting to talk about when they're high. Even when they're low, they seem to attract attention in the way that a car wreck does. But risk, well risk, is a real snooze. Other than a general warning about risk, what else can you say about it? The endless numbers of talking heads on television and radio programs that love to discuss the unknowable future returns of an endless number of investment products have nothing to say about risk. Yet the UPIA, and particularly the Restatement 3rd of Trusts (Prudent Investor Rule) (Restatement), have plenty to say about the notion of risk and the critical role that broad diversification of portfolio risk plays in assessing fiduciary conduct.

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."

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