All you need to know about Diversification

If you fail to diversify a client’s portfolio it can be a form of stock fraud. The broker should vary the types of stock purchased, in order to protect a client’s assets. Stock fraud strips the client of the protection diversification affords through over concentration. The most important shield against risk is the diversification of investment holdings. Some investments rise in value while the others fall. Some of the volatility of the overall return from a portfolio is smoothened by diversification. Diversification should be more than offset by the benefits of lower levels of risk and it may sacrifice some of the upside potential.

The strategy for managing a customer portfolio in order to limit risks is what diversification is. Investments are diversified among a variety of industry sectors and types of security instead if it being concentrated in one market sector. The portfolio at once contains less risk when it is less likely that all of the major sectors or specific types of them will be hit with a significant downturn. Advising clients to diversify their portfolio in order to reduce risks is a broker’s responsibility. The foremost issue in all efficient investments is proper diversification especially when individual stocks are purchased.

When an investment account or portfolio is over concentrated in a particular security, industry sector or a type of security, the risk of loss in the account is increased. It is the broker’s duty to recommend actions and to explain the increased risk in order to correct the problem. The account that contains only one individual investment is easy to recognize is over concentration. Accounts may also be over concentrated at times if:

• They contain only common stocks which include mutual funds that invest in common stocks, rather than a mix of common stocks, preferred stocks, and debt instruments (bonds).
• They contain investments that are limited to one particular industry such as telecommunications or industry sector such as health care or finance.

It is obligatory for the broker’s to carefully evaluate each client’s investment goals in order to provide for adequate portfolio diversification and not to give up potential returns. If the vast majority of a client’s total investment holdings in one sector are placed by the broker, and this sector declines significantly, the broker may be liable for it. All investors are unique, and careful strategies must be employed in order to properly diversify a client’s portfolio. Failure in complying with the strategies can result in negligence and malpractice liability when that portfolio sustains significant losses.

The cause of action for malpractice or negligence is based upon the duty owed by the broker to the customer and the breach of that duty by them. It includes the duty to exercise due care in connection with the account. Even if the broker did not have proper and actual knowledge as to the falsity of statements that they had made, the activity may constitute negligent misrepresentations. Failing to properly diversify the customer’s account may also be considered as neglecting the management of an account.

The reports, in general have shown that:

• Smaller companies typically have higher risk of failure.
• A greater degree of market volatility is experienced by Smaller-company stocks.
• Foreign securities have additional risks.
• Emerging markets typically have higher risk as they are underdeveloped markets.

For a client, the level of diversification depends upon a variety of factors which include an individual’s financial position and short and long term financial goals and also how the market is performing. Many portfolios are not properly diversified. Therefore an extended risk is being taken.