When investors create their own investment portfolio, often times they know they should diversify. It may be the most-preached concept in investing. “Don’t put all your eggs in one basket!” It’s generally good advice. Whether you invest in your 401(k), your Roth IRA, or your non-retirement account, diversification can help smooth out the returns in your portfolio, instead of experiencing the higher volatility that comes with investing in just one type of investment. Put differently, it can lower (but not eliminate) risk, and increase (but not guarantee) expected return.
The problem with diversification – and it’s really not a problem with diversification itself – is that many investors don’t do it properly. In my experience, most investors aren’t aware of how to diversify the right way, and they can make some costly mistakes when trying to craft a well-diversified portfolio. Here are three mistakes that I observe investors make on a regular basis.
Home bias is a behavioral finance concept that basically means we favor our own country. I’m not talking about immigration policy, restaurant choices, or the weather. Investors tend to favor investing in their own country. Roughly 50% of the global stock market is in the US, so if you were to invest in the global stock market as it is weighted by country, about half of your money would be in the US, and half would be outside the US. However, many investors simply invest in an index fund that mimics the S&P 500, or the Russell 3000, and assume that their portfolio is well-diversified. Unfortunately, when the US stock market takes a dip, it affects their entire portfolio. Or, when international stock markets do well, they miss out.
The following chart shows the difference in equity returns for various developed countries from 1997 to 2016.
Equity Returns of Developed Markets – Annual Return (%)
In US dollars. Source: MSCI developed markets country indices (net dividends). MSCI data © MSCI 2017, all rights reserved. Indices are not available for direct investment. Index performance does not reflect expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results.
You can see that returns in the US were in the bottom half of all developed country returns from about 2000 to 2007, meaning investors who only owned the stocks in the US underperformed. After 2007, things got much better for those same investors, and the US has been a top performer since then, except for 2017 (not pictured). However, history has not shown any one country to be a consistent outperformer. Global diversification can provide a better investment experience, and can enable investors to capture returns wherever they occur.
Another common mistake I see is extensive stock intersection. Stock intersection is what happens when someone owns the same underlying stock in more than one mutual fund or ETF. A small amount of stock intersection is normal. Some situations are worse than others, though. I recently analyzed a client’s 401(k), and of the six mutual funds they owned in their account, five of them owned pretty much the same companies – different amounts of those companies, but the same companies.
Stock intersection can be tough to avoid. Some mutual fund companies don’t follow a very specific strategy, so if investors own more than one mutual fund from that same company, they’ll end up with a lot of intersection. For example, an investor might own Fund X and Fund Y from the same company. Maybe Fund X targets small companies, and Fund Y targets mid-size companies. If they both have a lot of flexibility in their strategies, or if they don’t do a good job of following their strategy, stock from Company A might end up in Fund X and Fund Y.
There are a couple of problems here. First, mutual funds that don’t stick to their strategy make it challenging for investors to choose and stick with a strategy that makes sense for their unique circumstances. Second, stock intersection itself can be inefficient. It can create the need to place trades and rebalance an account which otherwise might not have been necessary.
Think of it this way. You’re throwing a party and you need a variety of flavors of La Croix. A good way to accomplish that goal would be to go to Costco and get a 24-can variety pack of La Croix. A bad way to do that would be to get three 8-can variety packs, open all three, and when your guests pull out a can, you redistribute cans from each case so each case contains a similar number of cans. You end up owning the same cans as the larger variety pack, you created extra work for yourself, and you probably paid more. What’s even worse is if you actually wanted a specific flavor, you bought cases according to your wishes, and the cases didn’t contain what you wanted. Or, they all contained the same flavors. That’s kind of what you run in to when you own a bunch of different mutual funds or ETFs that have extensive stock intersection.
Diversification of Advisor
Home bias and stock intersection can be problems associated with improper portfolio diversification, but the final mistake I want to point out is the idea of “diversification of advisor”. Many investors believe that because advisors might employ different strategies, give different recommendations, or create different portfolios, they should have some of their investments with one advisor, some with a second, and some with a third. They believe that they’ll benefit from this perceived “extra layer” of diversification.
That can create numerous problems. First, it can create even more stock intersection. If two advisors are managing money, there’s a chance they’ll both craft portfolios that end up owning similar stocks – either directly, or through mutual funds or ETFs. It’s inefficient on a macro scale, though, instead of a micro scale. Having more than one IRA or more than one nonretirement accounts can sometimes mean twice the trading costs, twice the account fees, and twice the paperwork. And for what? Those two IRAs might be pretty similar.
In cases where the accounts truly are invested differently, and the advisors have differing strategies, the overall strategy isn’t really a strategy at all. I live in Husker nation, so let’s think about a Nebraska football analogy. Let’s say Bill Moos conducted his search for a new head coach, and he really liked Scott Frost, so he hires him. But he realizes that we don’t know for sure that Coach Frost’s strategy will work, so he also hires Justin Fuente. For good measure, he also hires Mike Leach. Frost, Fuente, and Leach all know that a team needs a quarterback, and they might value different traits in a quarterback. They each recruit their preferred quarterback, and now the team doesn’t really have a clear path forward.
What’s the football team’s strategy in that scenario? What would you see on the field? A jumbled mess, probably. There isn’t a well-defined strategy, because there are three different strategies. In a similar way, diversification of advisor makes it challenging to pursue an overall strategy.
It’s silly to think about following competing advice in other areas of our lives. Imagine getting an opinion from two different doctors to take two competing medicines, so you take both. Imagine one surgeon telling you that you need surgery, and another telling you to avoid surgery, so you have surgery but tell them to just do half of the procedure. Imagine being wrongly accused of a crime, having one attorney tell you to settle, another telling you to go to trial, so you…do both? This area of finance just happens to be an easy area to employ competing strategies because money is easily divided. It’s convenient to make choices that might not be in your best interest.
Hiring a fee-only financial planner at Flagstone who considers the big picture and employs a comprehensive, intentional strategy can be a good way to make sure all of the parts are working together. Further, we believe that a low-cost, evidence-based approach to investing is the best way to navigate the unknown markets. If you need to form a strategy, we can help. If you are comfortable investing on your own and doing your own financial planning, avoid some of these common diversification mistakes. Form a strategy and stick with it, choose mutual funds or ETFs that actually do what you think they do, and don’t let your home bias prevent you from making the appropriate investment decisions.