THE QUANT by Richard Booth

THE REAL VICTIMS OF ENRON

Although plenty of folks lost plenty of money in the Enron debacle, the biggest victims may have been the employees whose retirement plans were invested heavily or solely in Enron stock.

As I have argued elsewhere, a broker who fails to recommend that a customer diversify violates the NASD suitability rule and his fiduciary duty (assuming that the customer relies on the broker). The Suitability Rule, Investor Diversification, and Using Spread to Measure Risk, 54 Bus. Law. 1599 (1999). The rule is the same for trustees under the common law. And the rule should be the same for employers. To be sure, ERISA expressly imposes a fiduciary duty on plan trustees and expressly requires that the trustee diversify "so as to minimize the risk of large losses unless ... it is clearly prudent not to do so." See ERISA §404. The trouble is it is never prudent not to do so.

On the other hand, if the plan is a profit-sharing plan or ESOP, diversification makes no more sense than compensating a CEO with shares in a mutual fund. But ERISA has exceptions for such plans. The real problem is that most employees do not understand the difference between a retirement plan and a profit-sharing plan. And ERISA more or less precludes the provision of investment advice, because of worries about conflicts of interest. If employees are going to be responsible for their own retirement, they need disinterested investment advice.

The shift away from traditional defined benefit plans is inevitable if US business is to be globally competitive. So it is not surprising that business has been pushing it. (What is surprising is that business has not been pushing for national health insurance. But that is for another post.)

But there is one another change that might change things. Under the corporation laws of most (if not all states), shares reacquired by a corporation (treasury shares) lose their vote. In the absence of such a rule, the board of directors would get to vote treasury shares, and they could easily insulate the corporation from takeover by buying back a majority of shares.

There is a huge exception to this rule. Shares held in a fiduciary capacity retain their votes. See DGCL 160(c); MBCA 7.21(c). So the board (or whomever the board appoints to serve as trustee) can vote the shares. How many companies do you suppose would load up their retirement plans with their own shares but for the fact that it augments takeover defenses?

The problem is that I cannot imagine any state being so bold as to be the first to make this change. The race to the bottom is one thing, but jumping off a cliff is quite another. One hope is that the framers of the MBCA might rethink this provision and catalyze change at least in those states that tend to follow suit.

WHY REASONABLE INVESTORS MUST DIVERSIFY

Rational investors diversify. Through diversification an investor can eliminate the risk that goes with investing in a single stock without any sacrifice of expected return. Studies indicate that one can eliminate more than 99% of company-specific risk with a portfolio of as few as twenty stocks. And with 200 to 300 stocks all company-specific risk is gone. The only risk that remains is market risk -- the risk that the market as a whole will rise or fall.

Moreover, investors have no real choice but to diversify. The fact that company-specific risk can be avoided means that the market sets the price of individual securities as if no such risk exists. To see why, suppose that market prices did reflect company-specific risk. Portfolio investors would buy up securities -- which would be underpriced from their point of view -- and hold them in portfolios that eliminate company-specific risk. The price of stocks would rise and eliminate any return attributable to company-specific risk. Undiversified investors would then be forced to pay higher prices for individual stocks even though the return remained the same. In other words, an investor who buys a single stock as a stand-alone investment takes more risk than is necessary to achieve the expected return from that single stock. Such behavior in an investor who is able to diversify is irrational by definition, because the fundamental goal of investing is to generate the greatest possible return at the lowest possible risk.

            Finally, it is virtually costless to diversify. Although it might at first seem as if only the very wealthy can afford to hold as many as 200 or 300 stocks, complete diversification is available very cheaply through mutual funds for investors with as little as $1000 to invest. In short, it is so cheap and easy for investors to diversify that it is simply unnecessary for investors to take company-specific risk. There is no downside to diversification. Accordingly, a rational investor must diversify. By the same token, it is fair to say that it is irrational for an investor who can do so not to diversify.