Question

Mike has decided that it is time he put his money to work. He has accumulated a substantial nest egg in a savings account at a local bank, but he realizes that, earning less than three percent interest, he will never reach his financial goals. After doing some research, he withdraws the money, opens an account at a local brokerage firm, and buys 500 shares of a large manufacturing company and 600 shares of a well-known retail store. From the beginning, his broker5 emphasizes that his portfolio is not sufficiently diversified with just two stocks. Over time, the broker convinces Mike to sell these two stocks to purchase stock in other companies. Two years later, Mike owns stock in 14 different companies and views his portfolio as well diversified. His cousin Ed, who has recently graduated from business school, looks at his portfolio and comments, “You are not very well diversified, as 10 of the stocks you own are considered technology stocks.” Mike tells Ed that he followed his broker’s recommendations and sold his original stocks to purchase the new stocks in order to attain a diversified portfolio. Ed comments that Mike’s brokerage firm is noted as a specialist in technology stocks. Mike is disappointed because he thought he was getting good advice about building a well-diversified portfolio. After all, Mike followed his broker’s advice to the letter, and why would his broker give him bad advice? 1. Comment on the broker’s ethics in recommending the sale of the original stocks to purchase a portfolio weighted so heavily toward technology stocks. Include in your discussion reasons why the broker may have followed the course of action that he did. 2. To achieve diversification, what other course of action could Mike have taken that would not have involved buying individual stocks in a variety of companies?

Answer 1

1. The broker's ethics in recommending the sale of the original stocks to purchase a portfolio weighted so heavily toward technology stocks can be called into question. While it is not necessarily unethical for a broker to recommend stocks in a particular sector or industry, it is the responsibility of the broker to ensure that the portfolio is well-diversified and suitable for the client's risk tolerance and investment objectives. In this case, the broker may have been motivated by his own interests or biases, such as a desire to promote stocks in the technology sector, which can lead to conflicts of interest. Additionally, the broker may not have taken into account the potential risks of a highly concentrated portfolio, which can result in significant losses if the technology sector experiences a downturn.

2. To achieve diversification without buying individual stocks in a variety of companies, Mike could have considered investing in mutual funds or exchange-traded funds (ETFs) that provide exposure to a broad range of stocks across multiple sectors and industries. These investment vehicles offer instant diversification and can be tailored to meet a client's specific investment objectives and risk tolerance. By investing in mutual funds or ETFs, Mike could have avoided the risks associated with holding a concentrated portfolio of individual stocks and achieved a well-diversified portfolio with less effort and expertise.