Diversification is a word that gets tossed around a lot in investing speak as a good thing. And it is. An obvious no-brainer is that you want to be diversified in order to reduce risk. Remember those people who worked for Enron and put all their money in Enron stock? Don’t do that.
But the tricky thing about diversification is that it’s not always what it seems. Even investors who have the best intentions when it comes to picking funds can end up with a portfolio that is either too risky or not risky enough, or just plain inefficient with its risk.
Our intentions, behavior research shows us, are no match for the hard-wiring of the human brain. When we are presented with a number of options at the same time — like selecting investment funds from a 401(k) plan — our grey matter has a hard time figuring out what to do. So to cover our bases our brains default to a kind of “more is better” mentality and we take a little of everything. It’s a lot like picking dinner from a large buffet: We take a spoonful of everything rather than thinking about what would be the most effective, or nutritious, meal.
In the investing world, this is called naïve diversification and it can have serious consequences on returns. We want to help you avoid these pitfalls.
Here are five reasons it is tricky to diversify well:
- We think more is better. We assume that more assets means we are more diversified. While more=better would be true if all the assets returns are uncorrelated, far too often we invest in very similar stocks that are driven by the same factors. The more assets we add, the less marginal benefit we gain from them — adding a 20th investment to your portfolio will probably not improve it meaningfully, even if it’s uncorrelated.
- We ignore how things are correlated. Diversification should be about diversifying risks, not investments. If we add extra assets that are strongly correlated with existing ones, we haven’t diversified anything. Conversely, if we add one new asset with a very low correlation to our existing portfolio, it can be very valuable — but often we don’t give it enough weight because we feel unsure about it.
- We believe equal is better. We typically divide the allocation equally amongst all assets. The problem is we do this regardless of the risk exposure each one has, and the number of options we’re presented with. Investors presented with three stock funds and two bond funds often choose an equal bit of each, and end up with 60 percent stocks. Those same investors presented with eight stock funds and two bond funds take a bit of each, and end up with 80 percent stocks. We tend to take one spoonful of everything that is offered — rather the right amount of just a few things.
- We avoid volatility. When it comes to pure diversification benefit, a diversifying investment with more volatility is actually better. An investment with low correlation and low volatility cannot offset a high-volatility asset. If we have a volatile asset, then we want another volatile — but lowly correlated — one to counter it. That’s why emerging markets bonds are better for diversifying a portfolio than treasury bonds – low correlation, more volatility.
- We think we should diversify our providers. Our intuition also tells us to spread investments across many financial service providers. But when we use too many different providers, it is that much harder to know if we are on track and save money on fees. And odds are that under the hood, all of our investments are actually very similar. Two retirement accounts of $50,000 at different providers are likely to cost more in fees in than one $100,000 account.
All these mistakes can cost you money. As Betterment showed in a recent white paper, co-authored with Richard A. Ferri, CFA, of Portfolio Solutions®, the more actively managed investments you have, the higher the likelihood you’re paying more in fund management fees, and the more likely you are to underperform a passive portfolio. Your tax burden is also potentially higher as individual investments rebalance. An overly concentrated portfolio means you’re not getting the full benefit of actual diversification but instead getting distracted with noise of too many little pieces.
Unfortunately for the DIY investor, there is no easy way around the complexity involved in picking and managing investments in a better way. Figuring out right diversification of assets is not easy — especially over time as the right level of risk you should take changes.
Here at Betterment, our pioneering software can provide the optimal amount of diversification perfectly tuned to your financial goals. You could do all the math to find out the perfect mix of assets for your goals, but chances are you have better things to do. Let us do it for you instead.
And next time you’re at a buffet, remember these lessons. Who knew investing better can help you eat better?