Maintaining standards in unusual times

By now, even the most ardent advocates of asset allocation have to be asking themselves whether they should just go to cash and wait for saner times.
I have to admit that in more than 25 years in the financial services business, I have never seen anything like this. Domestic and international equities are tanking, the credit markets are in crisis, commodities prices are bouncing like a Super Ball, a deep recession is looming, and the measures being taken to fight it are likely to set the stage for severe inflation at some point. Cash (perhaps even stuffed in coffee cans and buried in the backyard) is looking pretty good right now.
The problem for fiduciaries is that they have a duty to diversify unless it is clearly prudent not to do so (Metzler v. Graham, 5th U.S. Circuit Court of Appeals, 1997). In the Metzler case, the court reasoned that although no statute or regulation specifies what constitutes “diversification,” ERISA’s legislative history provides some guidance, noting: “The degree of investment concentration that would violate this requirement to diversify cannot be stated as a fixed percentage, be¬cause a fiduciary must consider the facts and circumstances of each case.”
In that case, the court faced the issue of whether the plan fiduciary had breached its duty to diversify by investing 65% of the assets in a single piece of real estate. The court held that there was no breach, since the plan, after purchasing the property, had sufficient cash remaining in the plan to cover projected plan payouts for the next 20 years.
This case points to the clearest example of when it is prudent not to diversify — that is, when the funding objectives of the investor can clearly be met without using a broader array of higher-return, higher-risk assets.
To further illustrate the point from personal experience, when I was an investment adviser some 15 years ago, I prepared a financial plan for a pro¬spective client with substantial wealth. The plan included a proposed well-diversified portfolio to fund his impending retirement. This gentleman had no heirs and few charitable intentions; his sole concern was to live out his life with adequate income.
As a successful businessman and fairly sophisticated investor, he formulated an alternative-investment strategy against which it was hard to argue. It included a laddered portfolio of high-quality municipal bonds that would meet his income needs by a wide margin. The portfolio was diversified by time and geography but involved only minimal exposure to other asset classes. Nevertheless, this concentrated portfolio met the test of prudence.
These examples serve to remind us that investing in a diversified portfolio is the generally accepted means to achieve a financial goal; it is not an end unto itself. For the fortunate few who have amassed sufficient funds effectively to prepay the bills associated with their goals, diversification among risky asset classes is neither required nor particularly prudent. The most prudent course is to narrow the portfolio allocation to conservative assets that preserve the principal and provide reliable cash flows for planned distributions.
Of course, when the markets are great and the economic outlook is bright, few are thinking about locking in their success. Companies with overfunded defined benefit pension plans pull “excess” funds out or reduce contributions rather than shifting to more conservative investment strategies that could protect the plan and its participants from the kind of environment we now face.
Similarly, in the best of times, individual investors are transfixed by their current good fortune, as opposed to the ultimate good their fortune is intended to serve. In effect, we forget about our future when we have the best opportunity to make sure our dreams become reality and we can’t stop worrying about our future when we are least able to secure it.
Now that the markets are dismal, there are few who have enough money to prepay their financial goals. Those who do should by all means cash out to make sure the opportunity does not slip away.
The rest of us — especially those serving in a fiduciary capacity — must recognize that we are not the exception to the rule. Diversification remains the best means of accumulating wealth to meet our financial goals. However, when the good times return, we should be especially vigilant in looking for the opportunity to be the exception and secure success when it is within our grasp.

Blaine Aikin is president and chief executive of Fiduciary360 LP in Sewickley, Pa.

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