Considerations

You’ve learned several concepts related to making suitable investor recommendations throughout the Achievable material. In this unit, we’ll discuss the strategies, styles, and techniques used to create suitable investor portfolios.

This chapter will specifically focus on investment considerations, including:

• Diversification
• Rule of 100
• ESG considerations
• Religious-based considerations

Diversification

Many financial professionals cite diversification as one of the most important investing principles. We live in an unpredictable, chaotic, and changing world. For example, who would’ve known that 2020 would be the year drive-in theatres would experience a resurgence? Or that the airline industry would take such a large hit? American Airlines (AAL) stock was trading around $30 per share in November 2019, only to fall to $11 per share in November 2020. To put this in perspective, an investor with a $100,000 portfolio fully invested in American Airlines stock in November 2019 would have less than $37,000 left in their portfolio one year later.

There are endless stories of investors losing significant amounts on concentrated investments in just one or a few companies. Examples include investors with large positions in Enron, Bear Stearns, and Silicon Valley Bank, all of which collapsed. For example, George Maddox was a plant manager at Enron that lost over $1 million in his retirement accounts due to Enron’s bankruptcy. His biggest fault was lack of diversification. He allegedly held almost all of his retirement savings (roughly $1.3 million) in Enron stock, which had benefited him during the stock’s dramatic rise in price in the late 1990s. However, his retirement nest egg came crashing down after revelations of Enron’s fraudulent accounting practices resulted in the stock becoming worthless.

Lack of diversification in an investor’s portfolio is a huge red flag. Even if the investment has performed well, investing significant sums of money into one or just a few investments is seldom a good idea. However, there are some exceptions. For example, a life cycle fund typically is comprised of many other mutual funds, which are each invested in dozens or hundreds of various securities. Index funds and exchange traded funds (ETFs) tracking broad indexes (like the S&P 500) also provide high levels of diversification with one investment.

A typical scenario related to a lack of diversification occurs with employment-related benefits. Employees of publicly traded companies are commonly provided company stock at a discounted price or even as a free benefit. An investor may feel comfortable investing significant amounts of money in the company they work for as they have an “insider’s view” of the business. Still, there are no guarantees (e.g., the George Maddox story). Financial representatives should identify when a lack of diversification exists, and recommend more variety to their clients.

Rule of 100

An investor’s age is a critical component related to suitability. In general, risk tolerance and age are directly related. The younger an investor, the more likely they’ll be suitable for aggressive strategies subject to higher risk. The older an investor is, the more likely they’ll be suitable for conservative strategies subject to lower risk.

We previously discussed the rule of 100 in the common stock unit, which is a general principle in finance. As a reminder, 100 minus the investor’s age determines the percentage of stock an investor should allocate in their portfolio. For example:

The rule of 100 is not absolute, meaning there are exceptions. For example, an 80-year-old multi-millionaire that prefers an aggressive approach with a small portion of their net worth could be suitable for a 100% stock portfolio. Or, a 25-year-old unemployed investor with large debt levels may have no stock exposure. The rule of 100 should be used as a starting point and applicable to the average investor at that age. However, financial professionals should always weigh the “big picture” and adjust recommendations if unique circumstances exist.

ESG considerations

Historically, most investors chose securities based solely on their risk and return profiles. Nowadays, many investors avoid securities that do not align with their personal values, regardless of suitability. Environmental, social, and governance (ESG) considerations are a popular version of what some analysts call “ethical investing.”

The industry standard for evaluating an investment for ESG considerations is the Morgan Stanley Capital International (MSCI) ESG score. MSCI is an investment research firm associated with the popular financial institution Morgan Stanley. The organization assigns a general ESG score of ‘leader,’ ‘average,’ and ‘laggard’ to the investments it evaluates.

Environmental considerations primarily focus on an investment’s environmental impact. MSCI considers the following factors when assigning an environmental score:

• Climate change impact
• Natural capital (e.g., water, lumber) usage
• Pollution & waste
• Environmental opportunities (e.g., using sustainable technology)

Social considerations primarily focus on an investment’s relationship with people and human rights. MSCI considers the following factors when assigning a social score:

• Human capital (e.g., health & safety)
• Product liability (e.g., product safety & quality)
• Stakeholder opposition (e.g., community relations)
• Social opportunities (e.g., improving health outcomes of customers)

Governance considerations primarily focus on the business structure of the related investment. MSCI considers the following factors when assigning a governance score:

• Corporate governance (e.g., ownership, worker pay)
• Corporate behavior (e.g., ethics, transparency)

MSCI evaluates the three pillars discussed above and assigns a score to the most popular investments in the market. For example, Plug Power Inc. (ticker: PLUG), a sustainable energy company, is assigned a ‘leader’ rating by MSCI (as of June 2023). A high ESG rating does not necessarily translate to returns. From January 2021 to June 2023, PLUG stock declined more than 80% in value. This dynamic can be tricky for investment advisers to manage, as clients may only accept recommendations of suitable securities if the ESG score is high. Ultimately, these considerations may result in fewer choices and lower rates of return. However, financial professionals must consider and prioritize their clients’ preferences.

Religious considerations

Falling under similar ethical-based investing principles as ESG considerations, some investors choose securities based on religious or spiritual beliefs. Depending on an investor’s choice of religion, spirituality, or denomination, various factors could be utilized to identify investments. For example, some Christian and Islamic investors avoid securities tied to addictive industries (e.g., tobacco, gambling).

While it can be difficult for an investor to identify securities that comply with their religious beliefs, several mutual funds maintain objectives tied to specific religions. Here are some examples:

• LKCM Aquinas Value Fund (ticker: AQEIX) - Catholicism-based fund
• Amana Income Fund (ticker: AMANX) - Islamic-based fund
• Six Thirteen Core Equity Fund - (ticker: TXDKX) - Jewish-based fund
• New Covenant Growth Fund (ticker: NCGFX) - Presbyterian-based fund

As with ESG investing, religious-based investing may result in fewer choices and lower rates of return. Again, financial professionals must consider and prioritize their clients’ preferences.