I recently listened to the always engaging Jonathan Clements being interviewed on the White Coat Investor podcast, during which he explained a neologism I'd not heard before to refer to a type of rookie mistake I recognized for having committed it: naive diversification.
As a quick review, diversification is a means of reducing portfolio risk. I own exclusively Apple stock and it tanks, I lose everything. I own all the stocks in the market via a total market index fund and Apple tanks, I'm fine. I've reduced my risk by spreading my exposure over a large pool of stocks. One can diversify in many ways, including across asset classes (stocks, bonds, real estate) and within asset classes (international vs. domestic stocks).
Naive diversification is based in part on the idea that when faced with excessive choices that need to be made all at once, people tend to diversify whether or not it makes sense to do so.
In one study, asking folks to select today food they would eat over the next several weeks led subjects to choose a greater variety of food. Asking control subjects to serially make the choice once a week of what food they would consume later that week led to reduced diversity in choices.
A similar effect was found with kids choosing candies at Halloween. Give a kid a basket of candies at the start of a block and ask them to choose their candies all at once for that block, and the kids choose a greater variety than if you let each kid go house to house and choose one candy at a time at each house.
How does this play out in behavioral finance? Ask someone with limited financial literacy to choose an investment in their 401k, and they tend to spread their investments over the funds available instead of following a cogent plan (such as what might be outlined in an investor policy statement).
But it gets worse. These same investors end up with an asset allocation that is unduly influenced by the choices available rather than logic. Let's create some examples to illustrate this phenomenon.
Joe Sixpack has a 401k with only three investment options, a stock index fund and two bond index funds. Good chance he'll end up with a 33/66 allocation because he just split his investments equally into the choices available.
Now take Jane Sixpack with her 401k with only three investment options, two stock index funds and one bond index fund. Good chance she'll end up with a 66/33 allocation for the same reason.
So, Crispy Doc, it sounds like naive diversification is a phenomenon that only newbies need fear! Since I read finance blogs I'm far too sophisticated to fall prey to this phenomenon, right?
Not so, says Jonathan Clements in the podcast. He gives an example of investors who decide to invest a portion of their funds on their own and send the other portion to a robo-advisor, even though the robo-advisor investment strategy will not automatically support the DIY strategy. This is precisely what I did when I first drank the finance geek Kool-Aid, attracted by the allure of automatic tax-loss harvesting.
Unless investors are somehow nudged to invest rationally, it appears we order based on the menu we are provided rather than what makes the most sense for us. This is not surprising to those physicians who have purchased whole life insurance because it's what the insurance agent masquerading as a financial advisor put on our menu.
It's all somewhat reminiscent of the tale of King Solomon, when faced with two women who lived in the same household and gave birth around the same time. When one infant died in the night, both women claimed to have birthed the surviving infant and sought the king's ruling for justice to be served. "Split the baby in half and give each woman her share!" he commanded a sword-wielding soldier, only to have the true mother protest while the non-mother accepted the judgment.
Your portfolio ought to be your baby - and as a parent, you need to consider it as a whole and avoid scenarios where inconsistent investment strategies figuratively split your baby in half by undermining your investment plan.
You will be tempted to invest in numerous modalities simultaneously (Via an advisor! On your own as a DIY investor! Via a robo-advisor!), because the human brain has built-in blind spots when it comes to maintaining discipline in behavioral finance.
You'll justify your irrational decision by framing it as a horse-race: let's put half in a robo-advisor and invest half as a DIY plan, and see which one comes out ahead! This, of course, goes against the investing principles you've learned about.
If the robo-advisor does better, are you going to move all your investments there? This is performance chasing (skating to where the puck was), something to avoid. Furthermore, you'll need a very long time horizon to see the effects of one investment modality vs. another, so a few years makes for inadequate comparisons.
While there are certainly instances where using more than modality can make sense, this should be the result of an explicit and coordinated investing plan rather than ordering one of everything off the investment menu before you.
Hopefully, an awareness of our flawed natural inclinations can keep us on high alert to detect and avoid investing mistakes due to naive diversification.