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William J. Bernstein

An Open Letter to Joe Nocera

Dear Mr. Nocera:

First, Iíd like to thank you for decades of perceptive, instructive, and entertaining reportage at Esquire, Fortune, and, most recently, The New York Times, and particularly for the superb duet you occasionally perform with Scott Simon on Saturday mornings. Last and certainly not least, even after 15 years, A Piece of the Action is still essential reading for anyone interested in the history of the American financial industry.

Now, however, itís time for a visit to the wood shed for your March 14, 2009 piece, "Madoff Had Accomplices: His Victims," in which you sternly take to task those who saw their lives ruined by historyís largest Ponzi scheme:

"Isnít the first lesson of personal finance that you should never put all your money with one person or one fund? Even if you think your money manager is "God"? Diversification has many virtues; one of them is that you wonít lose everything if one of your money managers turns out to be a crook."

Well, Joe, no, that is not what diversification means to me. "Diversification" does mean not putting all your eggs in one basket, but not in the sense that you imply. Diversification is spreading your bets among a very large number of securities. The average investor today can do this in reasonable safety with just a few mutual funds: a domestic and a foreign "total stock market" fund and a bond index fund might do perfectly well, thank you. (In fact, there are a handful of individual funds that Iíd be quite comfortable with as an investorís sole holding, particularly for a relatively small portfolio, say under $100,000 in size.)

It most certainly does not mean diversifying such purchases among many different mutual fund companies. The reason for this is simple: the Investment Company Act of 1940 provides the typical mutual fund investor with about the best statutory protection against fraud available in the world. An investor who can buy an index fund from Vanguard or Fidelity, or a total-market ETF from Barclayís, would have to be out of his mind to buy more expensive funds from additional companies in the name of "diversification."

And it also certainly shouldn't mean diversifying among advisors.

Think about it, Joe. Do you "diversify" among doctors, lawyers, dentists, plumbers, or accountants? Most people do not, nor do they have to. The reason for this is simple: all four of these professions are highly regulated, and their practitioners deviate from standard procedure only at great peril to their livelihood. In most circumstances, one good dentist or accountant ought to be all you need; you donít hire three or four in case one cheats you.

If a physician fails to recognize and treat with powerful antibiotics more than one or two cases of obvious bacterial pneumonia, her license will get yanked with gusto. Ditto for the accountant or attorney who regularly falls below the standard of practice.

The same, alas, is not true for financial practitioners. The depressing fact of the matter is that the federal and state governments do not protect investors in the same way that they do the clients of other professions. Amazingly, stockbrokers are not considered fiduciaries at all, as are practitioners of all other learned professions.

This state of affairs is, in some respect, a historical accident. All the professions Iíve mentioned, except finance, have long since recognized that regulation of minimal standards of training and practice is a necessity. It happened, for example, to the medical profession a century ago with the publication of the Flexner Report. Bluntly put, thereís no chance that your doctor, dentist, or attorney is a high-school dropout. Your stockbroker, however, just might be.

Itís high time that the same kinds of practice and training standards applied to other professions were applied to financial management. Financial regulators should no longer tolerate financial advisors or brokers who deploy underdiversified portfolios of a few dozen individual securities, who invest client assets in high-expense, high-turnover funds, and especially those who use opaque strategies. Fraud, negligence, and abuse need to be much more systematically sought out.

The highly idiosyncratic strategies of many hedge funds are especially problematic. I would have few qualms about restricting the purchase of these products to only the most sophisticated institutional investors, with no individual ownership allowed through brokerage or fund-of-fund channels.

If Bernie Madoffís unfortunate clients are guilty of anything, Joe, it is of naively expecting their government to provide the same sort of protections that they get when they have their drains repaired or their teeth drilled. Itís time our elected officials dragged the investment industry, kicking and screaming, into the modern era.

Copyright © 2009, William J. Bernstein. All rights reserved.

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