Brokers: Know Your Firm's Asset Allocation and Diversification Recommendations

previously outlined some advertisements that wirehouses (Salomon Smith Barney, Morgan Stanley, Prudential Financial, and Merrill Lynch) placed in major newspapers and magazines across the country. These ads contained general concepts that reps need to know, such as discouraging certain unsuitable trades and monitoring customer portfolios.

The printing presses continue to produce mass marketing materials relating to all types of advice that reps need to know. Considering that the investing public is nervous about their investments and the markets, we expect this trend to continue in full, if not greater, force. Some of the advice is quite precise. Of course, the more precise the advice, the more brokers will hear about it in customer arbitrations. The strong upward trend in arbitration filings, incidentally, should keep pace with the strong upward trend in wirehouse advertising.

Two areas in which firms are issuing rather precise guidance are asset allocation and diversification, as well as the related concepts of rebalancing and market timing.

Let's start with diversification. We have seen an outpouring of advice from firms with respect to this topic. For example a major brokerage firm provides the following "Guidelines for Diversifying the Stock Portion of Your Portfolio":

8 to 25 stocks in at least 6 to 8 sectors with different investment characteristics;

No more than 25% of the total portfolio value in any one industry;

No more than 15% of the total portfolio value in any one stock; and

A minimum of approximately 3% to 4% of the total portfolio value in each security.

These guidelines, the firm states, "are not set in stone but should provide a starting point". But reps who stray from these guidelines should be prepared to defend themselves. The reps should have written documentation, preferably signed or written by their customers, for not acting in accordance with the firm's guidelines.

Second, we see an outpouring of advice by brokerage firms as to asset allocation. Although asset allocation recommendations are not new, what is new is the extensive degree to which firms are circulating the asset allocation recommendations among the investing public.

The asset allocation recommendations vary widely. For example, consider the asset allocation recommendations of the same major firm that distributes the diversification guidelines noted above. For asset allocation, or "Strategic Asset Allocation Guidelines", as the firm phrases it, "aggressive growth" (highest risk category) investors should have the following allocations in their portfolios:

40% large cap stocks, 20% mid cap stocks, 20% small cap stocks, 15% in foreign developed stocks, and 5% in foreign emerging market stocks. By comparison, a wirehouse provides this "hypothetical" guideline for its "very aggressive" (highest risk category) investors:

10% high yield bonds, 10% balanced (common stocks and investment-grade bonds for long term growth), 20% large cap growth, 20% mid-cap value, 20% international, and 20% aggressive growth (stocks of smaller, rapidly growing companies for long-term appreciation). Accordingly, reps need to pay attention to what their firm, and what other major firms, suggest for asset allocations.

Moreover, to maintain appropriate diversification and asset allocation, firms also promote "rebalancing" of investor portfolios. One firm describes rebalancing as a "classic investment discipline". The firm suggests that rebalancing should be done quarterly or regularly, and notes that rebalancing "generally reduces volatility for your portfolio".

Finally, market timing is discouraged. Studies show that market timing nearly is impossible to do correctly over any considerable period of time. One firm displays the popular study that examined the 50 best days in the stock market between 1982 and 2000. That study found that if an investor missed the 50 best days, the annual returns would be reduced from 13.3% to 3.7%.

Most reps know that they should asset allocate, diversify, rebalance and avoid market timing. But now all reps can be sure that their customers (or their arbitration counsel) will know them too. Therefore, reps must make sure they practice what their firms preach.