Failure to Diversify or Overconcentration of Investments in Accounts Can Create Unnecessary Risk
Investors hire brokers and investment advisers to manage their investment portfolios in a professional and efficient manner with the help of their expertise in financial markets.
All too often, financial advisors focus on their personal gains and recommend investments with high commission fees that pose serious risk to their clients’ portfolios.
One way this occurs is by recommending multiple investments in one sector, or “over-concentrating” a client’s portfolio or lack of diversification.
In the event of a market downturn, over-concentrated portfolios risk suffering significant losses all at once, while diversified portfolios survive over the long term.
Portfolio Management: An Overview
To successfully manage a client’s investment portfolio, an investment advisor evaluates the risk tolerance and financial objectives for that particular investor. “Risk tolerance” refers to the level of risk the customer is comfortable with in the course of their investments. With these factors in mind, advisors recommend the sale and purchase of different investments that are suitable for the individual investor.
The recommended investment must also be suitable in light of the client’s entire portfolio. The key to an effective investment portfolio involves a mixture of long-term assets. Including a variety of investments provides balance to the portfolio and protects against risk. Investors with a higher risk tolerance focus their investments on more volatile assets, while those with a low risk tolerance lean toward stable investments like stocks and bonds.
Predicting the ups and downs of financial markets is impossible. With that in mind, advisors balance client portfolios with an array of different investments in different industries. Otherwise, when certain industries sink in the markets, investor portfolios including multiple investments from that industry suffer hefty losses. Spreading out investments over several sectors protects investors against the unpredictability of the market. For example, one firm published the following in its marketing materials:
No single asset class performs best in all economic environments. Therefore, experts suggest that a sound investment portfolio should be diversified – that is, invested in a variety of asset classes that have distinct, yet complementary, characteristics.
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Rather than just one asset class, an asset allocation strategy includes a blend of different investments that reflects your specific financial goals and tolerance for risk.
The easy to understand explanation for asset allocation and diversification is simply you “do not put all of your eggs in one basket.” In fact, it has been determined that 91.5% of a portfolio’s performance is a direct result of asset allocation, whereas only 6.7% of the performance is linked to security selection and a mere 1.7% to market timing.
Suffering significant losses due to a lack of diversification places investors in a tough position. A major financial loss impacts investors financial and emotionally, especially those with a low risk tolerance. If you suffered investment losses due to a lack of diversification, your financial advisor may be liable.
Can I Recover Investment Losses Due to Lack of Diversification?
FINRA Rule 2111 requires financial advisors to recommend investments that are suitable for their client’s investment portfolio. Regulation BI (the “Best Interest Rule”) demands that all recommendations be in the best interest of the customer. Investments that result in a client’s investment portfolio being over-concentrated are unsuitable and never in the best interest of the customer. To comply with FINRA’s suitability rule, an advisor’s recommendations must result in a well-diversified investment portfolio. If an advisor recommends trades that result in your portfolio being over-concentrated, consult with an investment losses attorney. You could hold your advisor liable for the lack of diversification in your portfolio.
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Many of our cases in the last seven years have involved a broker’s failure to diversify investors’ accounts. For example, thousands of investors in Puerto Rico lost billions of dollars because Puerto Rico brokerage firms over-concentrated their best clients’ accounts in Puerto Rico bonds and Puerto Rico denominated closed-end bond funds, which could only be purchased by residents of the island. The over-concentration of clients’ assets in fixed income securities of a single geographic area was a disaster when the Puerto Rico credit market collapsed in September 2013. Another example is the impact the March 2020 COVID-19 market crash had on investors whose assets were over-concentrated in the energy, hotel, airline, and/or cruise-line industries. Those investors who held diversified portfolios weathered the storm while the others suffered significant losses, particularly those investors with leveraged and over-concentrated accounts that received margin calls and were forcibly liquidated.
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