Failure To Diversify
Diversification protects against risk, not only the proverbial “don’t keep all your eggs in one basket,” but also the reduction of risk through asset allocation. For example, declines in one asset class, i.e. stocks, may be countered by increases in other asset classes, such as bonds. Inflation may cause interest rates to rise thereby adversely affecting bond prices, but the same increase in inflation may cause stock or equity prices to rise. Accordingly, diversification as to asset classes protects against risk.
While the purchase of any particularly speculative security may not be actionable as unsuitable, the over concentration of an investors portfolio on one security, or the securities of one issuer, may be actionable as a failure to diversify. See In re Rafael Pinchas, Exchange Act Rel. No. 41816, at 10-12 (Sept. 1, 1999)(“the suitability rule can be violated if a representative’s recommendations are quantitatively unsuitable”)(emphasis added).
FINRA Conduct Rule 2310, with respect to the suitability of investment recommendations, and that duty to only make recommendations consistent with the customer’s stated tolerance for risk or expressed investment objectives, “is especially true where a broker/dealer’s recommendation leads to a high concentration in the customer’s account of a particular security or group of securities that are speculative.” See, e.g., In re Clinton Hugh Holland, Exchange Act Rel. No. 37991, at 8 (Dec. 21, 1995), aff’d., 105 F.3d 665 (9th Cir. 1997)
Over concentration or “the breach of the duty to diversify constitutes an independent basis of liability, separate from a breach of the general duty of prudence.” Liss v Smith, 991, F. Supp. 278, 301 (SDNY, 1998)(emphasis added); See also Stephen Torlief Rangen 52 S.E.C. 1304, 1308 (1997) (finding that broker’s recommendations were unsuitable, where they resulted in 80% of the equity in customers’ accounts being concentrated in one stock – ‘”by concentrating so much of their equity in particular securities, [the broker] increased the risk of loss for these individuals beyond what is consistent with the objective of save, non-speculative investing”).
Unlike over concentration where a securities broker may recommend that a portfolio be excessively invested in the securities of one company, the securities of one issuer, or the securities of one economic sector, such as technology or internet related companies, or the securities of financial institutions, failure to diversify cases are subtly different.
Failure to diversify cases generally arise when a customer receives a lump sum retirement distribution often in the form of company stock, or as part of on-going compensation from an employer, the investor receives stock options relating to the purchase of the employer’s underlying securities. Many of these same people are reluctant to sell these securities because they believe in the companies with whom they were associated.
However, under such circumstances, securities brokers may have a special duty to objectively recommend that the customer diversify their financial holdings. All recommendations must be based upon the customer’s other holdings, and no recommendation, or a “hold” recommendation is still a recommendation, even if the over-concentrated position was not initiated by the broker. Such conduct may be actionable.
If your stockbroker or investment professional as part of any investment recommendation or strategy, fails to diversify your overall investment portfolio or over concentrates your investments in any security, the securities of companies in a particular industry or economic sector or sub-sector, and you suffer losses, you may have a claim against your stockbroker or investment professional, including the securities firm with whom they are associated for the failure to diversify.