STOCKBROKER PROBLEMS
Diversification or "Who put Humpty Dumpty on the Wall Anyway?"
The ‘mantra’ of prudent investing is ‘diversification’. Modern Portfolio Theory requires that investors divide their assets into 3 general asset classes; stocks, bonds, and cash. However, victims of the “tech wreck” include elderly and retired folks who should never have been exposed to the telecom and technology sectors in the amounts leading to the Humpty Dumpty “great fall”. However, while technology issues make up a small portion of the S & P 500, fallout from the “tech wreck” continues to haunt those whose portfolios were concentrated in technology and telecom issues over the past few years. “Great Fall’ never seems to include in the boxes as the retirement investment objection.
For many folks who listened to their brokers to “stay the course” with their telecom and technology stocks and “it will come back”, what is true is that their investment decisions were informed and influenced by their relationship of trust and dependence upon their broker and brokerage firms. The firm’s advertisements foster the belief that the brokerage firm earns their trust ‘one investor at a time’ or its ‘uncommon wisdom’ market wise.
As Dan Solin indicates in his book, Does Your Broker Owe You Money, when customers have the gall and temerity to make a claim against their broker, the brokerage firm says that their brokers are not fiduciaries and that it was the customer who made all the investment decisions. The FA (financial advisor) or FC (financial consultant) or AE (account executive) are to be blameless along with their financial analysts for their “strong buy” recommendations of Worldcom and Enron when they were only days away from Bankruptcy.
When the next Worldcom, Enron or IPO spinning scandal occurs, will the brokers and other king’s men be able to put Humpty Dumpty together again? Customers should not allow themselves to be victims of stockbroker misconduct, and should know that they may be entitled to an investment recovery.
The Duty to Diversify
Diversification is necessary for prudent investing. "One of the time-honored investment maxims is that risk can be reduced by diversification. The Nobel Prize in economics was awarded to Harry Markowitz in 1990 for a rigorous explanation of this phenomenon. It is important to have in one's portfolio stocks that do not all depend on the same economic variables, such as consumer spending, business investment, housing construction, and so forth. “The single most important step most investors can take to immediately improve the long range performance of their portfolios ¼ is to properly diversify their common stock investments.” Norman Fosback, Stock Market Logic 252 (Institute for Econometric Research, 1985).
There is general agreement that it takes at least 10, and usually 15-20, non-correlated stocks to achieve adequate diversification and thereby reduce nonsystematic risk.
The duties increase if the broker is a fiduciary. A fiduciary must diversify unless it is clearly prudent not to. "Diversification is a uniformly recognized characteristic of prudent investment and, in the absence of specific authorization to do otherwise, a trustee's lack of diversification would constitute a breach of its fiduciary obligations.
As can be seen, diversification is the norm, the default condition. Whether or not the broker is a fiduciary, the expected treatment in the broker-customer relationship is a diversified portfolio. Anything that deviates from that needs to be fully substantiated and justified. The decision not to diversify must be consistent with the customer’s investment objectives and risk tolerances, as well as fully grounded in the broker’s research into (a) the portfolio design and (b) the specific securities selected. It should not be sufficient simply to have a reasonable basis for recommending a particular security; rather, the broker must also have reasonable grounds for deviating from the norm of prudent investing.
Even assuming that the broker has met all of those threshold tests, it still is not enough. The broker can’t just sit back and shut his eyes. Having exposed the client’s portfolio to substantial nonsystematic risk, he has to take measures to prevent those risks from decimating his client’s assets. The risks wouldn’t be there if he had adequately diversified. Since he has voluntarily and deliberately imposed them on the client, he has an obligation to manage them or make sure that the client knows how to manage them.
Loss management is one of the essentials in stock market investing. There are various ways to control unsystematic risk. Stop loss orders or percentage loss triggers, though not foolproof, are probably the simplest. However, whatever the broker puts in place, it implies that he either had a discussion with his client about the matter or that he has taken discretion over the decision of when to sell. If there was no discussion with the client and no discretionary action, the broker has failed (a) to alert the client about the possible consequences of the nonsystematic risks he has put in the portfolio and (b) to take necessary and prudent measures to safeguard his client’s money.