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What are fiduciary standards and duties related to diversifying a client's investment portfolio?

An Advisor’s Duty to Diversify

Diversification of a portfolio reduces risk by ensuring that the variety of investments in the portfolio provides, theoretically and hopefully practically, for assets that increase in value to offset others that decrease. Diversification is effective since it recognizes that movements in asset values are not uniform and are often negatively correlated. The main purpose of diversification is not to merely acquire a greater number of assets, but rather to acquire those assets whose responses to potential events or influences will offset each other. The objective of diversification is to minimize the risk of having too few investments.

A fiduciary should perform due diligence in making the determination whether to diversify, and a fiduciary should diversify unless there is a very good reason not to diversify. It is a requirement that a process of evaluating whether the fiduciary assets should be diversified be put into place and followed.

Diversification Standards

The fiduciary standard requires an advisor to diversify the investments of the account: unless the advisor reasonably determines that, because of special circumstances, the purposes of the account are better served without diversifying.

For investments made by the fiduciary, the standard is clear - the fiduciary has an affirmative duty to diversify. The fiduciary should make an initial diversification decision and periodically monitor and adjust the categories of investments held and the proportions according to each category. In order to afford the widest risk reduction, there should be diversification of

  1. Classes of investment, such as equities versus fixed income;
  2. Industry sectors, such as industrials, financials, consumer discretionary, etc.;
  3. And individual companies

Protection from the risk of holding securities of specific companies can be offset by purchasing securities that react to changes and events in different ways.

A fiduciary can diversify the risk in a smaller portfolio by using mutual funds to spread the risk of loss.

Process for Diversification Decisions

Documentation

Documentation of an account is important. Each step and decision, including but not limited to the following, should be thoroughly documented for future substantiation of decisions made. Because a fiduciary’s investment processes are evaluated based on whether they acted prudently and not whether they achieved exceptional results, being able to show the process that a fiduciary undertook with respect to investment decisions is vitally important, particularly where there is a lack of diversification or certain special assets (such as non-traditional assets) are bought or sold.

At a minimum, clearly document the following:

  • Initial review of account
  • Objectives of account
  • Investment program
  • Annual reviews
  • Substantiation for specific decisions varying from organizational norms
  • Conclusions on advisability of retaining or disposing of specific assets

Beneficiary Consent

  • Seek Consent. Whenever the financial advisor engages in a significant shift in investments or makes a decision against diversification, the financial advisor should seek the consent of the client.
  • Consent to Not Diversify. For consent to be some protection for a financial advisor who determines that it is prudent not to diversify a portfolio, the client should be fully informed of the circumstances and the potential consequences of the decision.

G46288-44