You’ve learned several concepts throughout the Achievable material about making suitable investor recommendations. This unit focuses on the strategies, styles, and techniques used to build suitable investor portfolios.
This chapter specifically focuses on investment considerations, including:
Many financial professionals cite diversification as one of the most important investing principles. Markets and businesses can change quickly and unpredictably. For example, few people expected drive-in theatres to experience a resurgence in 2020, or the airline industry to take such a large hit. American Airlines (AAL) stock traded around $30 per share in November 2019, then fell to about $11 per share in November 2020. Put differently, an investor with a $100,000 portfolio fully invested in American Airlines stock in November 2019 would have had less than $37,000 one year later.
There are many examples of investors losing significant amounts of money because they concentrated their portfolios in one company (or just a few). Well-known cases include large positions in Enron, Bear Stearns, and Silicon Valley Bank, all of which collapsed. For example, George Maddox was a plant manager at Enron who lost over $1 million in retirement accounts due to Enron’s bankruptcy. His main issue was a lack of diversification: he allegedly held almost all of his retirement savings (roughly $1.3 million) in Enron stock. That concentration helped him during the stock’s dramatic rise in the late 1990s, but it also meant his retirement savings collapsed when revelations of fraudulent accounting practices caused the stock to become worthless.
A lack of diversification is a major red flag in a portfolio. Even if a concentrated investment has performed well, putting significant sums into one or a few investments is rarely appropriate.
There are some important exceptions. For example:
A common diversification issue comes from employment-related benefits. Employees of publicly traded companies may receive company stock at a discount or even as a benefit. An investor might feel comfortable investing heavily in their employer because they believe they have an “insider’s view” of the business. Still, there are no guarantees (as shown in the George Maddox story). Financial representatives should recognize when a client is overly concentrated and recommend a more diversified approach.
An investor’s age is an important suitability factor. In general, age and risk tolerance tend to move together:
We previously discussed the rule of 100 in the common stock unit. This rule is a general guideline for asset allocation: subtract the investor’s age from 100 to estimate the percentage of the portfolio that should be allocated to stocks (with the remainder typically allocated to bonds). For example:
| Age | Stock % | Bond % |
|---|---|---|
| 30 | 70% | 30% |
| 45 | 55% | 45% |
| 60 | 40% | 60% |
| 70 | 30% | 70% |
The rule of 100 is not absolute. It’s a starting point for the average investor at a given age, not a requirement. Unique circumstances can justify very different allocations. For example:
Financial professionals should consider the full client profile and adjust recommendations when circumstances warrant it.
Historically, many investors chose securities primarily based on risk and return. Today, many investors also consider whether an investment aligns with their personal values, even if that limits the available choices. Environmental, social, and governance (ESG) considerations are a common form of what some analysts call “ethical investing.”
A widely used industry standard for evaluating ESG characteristics is the Morgan Stanley Capital International (MSCI) ESG score. MSCI is an investment research firm associated with Morgan Stanley. MSCI assigns a general ESG score of ‘leader,’ ‘average,’ or ‘laggard’ to the investments it evaluates.
Environmental considerations focus on an investment’s environmental impact. MSCI considers the following factors when assigning an environmental score:
Social considerations focus on how a company relates to people and human rights. MSCI considers the following factors when assigning a social score:
Governance considerations focus on the company’s structure and oversight. MSCI considers the following factors when assigning a governance score:
MSCI evaluates these three pillars and assigns ratings to many widely followed investments. For example, Plug Power Inc. (ticker: PLUG), a sustainable energy company, is assigned a ‘leader’ rating by MSCI (as of June 2023). However, a high ESG rating does not guarantee strong returns. From January 2021 to June 2023, PLUG stock declined more than 80% in value.
This can create a practical challenge for investment advisers: a client may only accept recommendations that meet certain ESG preferences, even when those preferences reduce the available investment universe. In some cases, that can mean fewer choices and potentially lower returns. Regardless, financial professionals must consider and prioritize client preferences when making recommendations.
Similar to ESG-based ethical investing, some investors choose securities based on religious or spiritual beliefs. Depending on the investor’s religion, spirituality, or denomination, different screens may be used. For example, some Christian and Islamic investors avoid securities tied to addictive industries (e.g., tobacco, gambling).
It can be difficult for an investor to identify individual securities that comply with specific religious beliefs. However, several mutual funds maintain objectives tied to specific religions. Here are some examples:
As with ESG investing, religious-based investing may result in fewer choices and lower rates of return. Financial professionals must still consider and prioritize client preferences.
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