Failure to Diversify Creates Unnecessary Risk for Clients
Diversification is necessary for prudent investing. One of the time-honored investment maxims is that risk can be reduced by diversification. 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. A broker or advisor must diversify unless it is clearly prudent not to. Diversification is a universally recognized characteristic of prudent investing and, in the absence of specific instructions from the client to do otherwise, a broker or advisor’s lack of diversification of a client’s account may constitute a breach of that broker or advisor’s fiduciary obligations.
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Whether or not the broker or advisor 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.