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| > Investing > Fiduciary Focus |
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| Some Items of Interest to Advisors |
| by
W. Scott Simon
| 02-05-09 |
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To kick off 2009, I thought it might be a good idea to cover a few items that don't merit treatment in a column on their own but nonetheless may be of interest to advisors.
Losses Versus Declines in Value
The mainstream media, over the last six months in particular, has been busy hyperventilating over "plunging" markets, "record" losses, the "unprecedented" failure of our financial system, etc.
Amid this breathless reporting, it might be useful for advisors to remind their clients that unless they have actually sold the holdings in their portfolio, they have experienced only "paper" losses. More specifically, advisors with clients in such circumstances should tell them that their portfolio has suffered "declines in value," not actual "losses." The only way that these paper declines in value can become "locked in" as actual losses is if investors sell their holdings. When investors do that, they have forfeited forever the ability to recover what had been only paper losses (declines in value).
Another thing that advisors can tell their clients: recoveries in financial markets, after prolonged downturns, tend to hold quick, sudden, and unexpected bursts of spectacular returns. Investors wishing to capture the benefits of such recoveries must stay in their seat and fight the urge to sell their portfolio holdings.
Guarantees and Risk
With the downturn in financial markets and the consequent decline in value of participant accounts at ERISA-based retirement plans such as 401(k) plans, there's been no end of commentary about the nature of financial markets or even whether capitalism itself will survive. (Psstt, you heard it here first: not only will our capitalistic system survive, but its built-in resiliency will eventually provide even greater amounts of wealth for more and more people in America and around the globe).
Some of these commentators have spoken of "guaranteed" returns generated by "safe" investments such as a special class of government bonds. This kind of commentary exposes an essential disconnect between how financial markets really work and how many people (including those who should know better) wish they would work by waving their magic wands.
I've cited repeatedly over the years in this column the "central consideration" of fiduciaries whose investment conduct is governed by the 1994 Uniform Prudent Investor Act: the requirement to make a rational trade-off between a portfolio's risk and return. This requirement (the legislative genesis of which was ERISA) presupposes that risk is ever-present in financial markets; it never goes away.
Yet many people believe mistakenly that risk disappears when financial markets are in ascent. When times are good, the risk of a portfolio concentrated in a relatively few investments often seems extremely remote. In the heady days of wildly advancing stocks, diversification looked like a pretty dumb strategy because it limited up-side portfolio return. Many people also believe mistakenly that risk reappears in spades when markets return to earth--or when they go underground, as they have over the past year.
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| W. Scott Simon is an expert on the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule). He is the author of two books, one of which, The Prudent Investor Act: A Guide to Understanding is the definitive work on modern prudent fiduciary investing. Simon provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. He is a member of the State Bar of California, a Certified Financial Planner, and an Accredited Investment Fiduciary Analyst. Simon's certification as an AIFA qualifies him to conduct independent fiduciary reviews for those concerned about their responsibilities investing the assets of endowments and foundations, ERISA retirement plans, private family trusts, public employee retirement plans as well as high net worth individuals. For more information about Simon, please visitPrudent Investor Advisors, or you can e-mail him at wssimon@prudentllc.com The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar. |
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