Naive Diversification, Robo Advisors, And Splitting The Baby In Half

crispydoc Uncategorized 8 Comments

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.

Comments 8

  1. Great analogies CD.

    I was tempted at one point too to put a small % of money into a robo advisor and see if it indeed would outperform my DIY method. You are right, that if it had performed better, I would have likely chased performance and shifted even more (or try to simulate the choices it made with my DIY allocation).

    Another problem is false sense of diversification if they are buying things which have a lot of overlap. I doubt most people would make this mistake but if you buy total stock market in vanguard index and then do the same in Fidelity index, you have pretty much 100% correlation and no additional diversification.

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      Author

      Xrayvsn,

      You are far from alone in testing yourself against a robo, and they offer some nice perks. It just needs to be part of the greater plan, which is particularly hard if not impossible to coordinate with a robo.

      I’d heard of people diversifying among brokerages in case one turns out to be the next Lehman (not to diversify assets but to diversify custodians) from shellshock after 2018.

  2. Diversification is a really important completely misunderstood concept. It is the notion that owning 1 stock is more risky than owning a portfolio of stocks, so the AAPL example is perfectly valid. But diversity is not linear. The most diversity occurs when you buy the second stock, some lesser amount with the third etc. Diversity traces a curve that is asymptotic, and it essentially reaches its asymptote at 20 or 25 stocks. Not 100, not 3000. The data shows after 25 or so stocks across sectors your portfolio is converted from having single stock risk, to having market risk, and once market risk is achieved adding more and more does not improve diversity and reduce risk but can actually increase risk. Risk is NOT linear. It is the square root of variance and as such follows a square root functions expression. Square root of 2 and square root of 3 and square root of 5 adds up to 5.382, not 10. Even if you square 5.382 it becomes 28.969 so the relationship between risks among a group of stocks is curve-linear not linear. This is what gives the efficient frontier its curved shape, and why the tangent portfolio is the most return for the least risk, because you are combining 2 quantities (risk/reward) one being linear one being not linear.

    So you say linear schmenear WTF are you talking about??? The point is boggleheads tend to practice PhD diversity. PhD = Piled higher and Deeper. Boggleheads suffer from the delusion if 25 is good 2500 is better!!! That is not the case because the curve becomes asymptotic and a huge big change on the horizontal axis results in a very tiny little change if measurable on the vertical axis. When you buy a fund say VTI, you buy market diversity automatically. VTI has a predicted risk and a predicted reward by doing the averages over time. Having a risk and reward allows you to compare investments for performance. Lets say you own 20% US Bonds, 60% US Stocks, and 20% emerging markets on the notion EM increases your diversity and reduces the risk (PhD theory). EM over time is a crap investment. It’s return is 8.3% but its risk is 23%. US stocks sport 10.9% return and only 15% risk. So why would you buy EM? More risk less return = bad investment. Remember risk is a measure of how the asset performs especially in a down market. If the US market drops in half, the asset (EM) with greater risk does even worse. You would expect EM to drop 75% based on risk profile. The real kicker is what happens on the way back up. If you drop 50% you need to make 100% to get back even. If you drop 75%, the magic number is 150%, but wait a minute EM’s rate of return is 25% worse than US Stocks. So your EM ain’t got no motor when it comes to recovery. Lousy return and a greater drop means the time it takes to get back to zero in EM is greatly magnified. US stocks are back and making money way before EM gets even, BAD INVESTMENT.

    So what is all the hub bub about diversity? Diversity can actually provide you with free money, but to collect the payday the diversity needs to be non correlated. Stocks and bonds are non correlated. Stocks and GLD are non correlated. US stocks and EM are quite correlated. This means as stocks oscillate bonds do not and as stocks oscillate GLD does not, As stocks oscillate EM oscillates a near equivalent amount. This is where the free money of diversity pays off, especially if you re-balance over decades. On the way up you sell a little profit in stocks (sell high) and stash that value in bonds. Come the crash you now sell some bonds which holds the increased value and buy some stocks (buy low), rinse and repeat. This is automatic risk management. Throw your bogglehead PhD in the trash and use real non correlated diversity to get rich. Sorry for the length

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      Author

      Gasem,

      Enjoy your description of the physics of risk, reward, volatility and the need to ensure your alleged diversification is non-correlated; this was something that the Vanguard REIT was roundly criticized for in 2008 (real estate is ostensibly non-correlated, yet the REIT behaved like what many called a real estate flavored stock with significant correlation to the total stock market indices).
      I’d similarly read (perhaps in one of the Bernstein books?) that beyond 25-30 you reach a point of diminishing returns in diversifying within an asset class. Big ERN just wrote a pretty fascinating and provocative post on whether the small and value premiums are likely to carry forward over time.
      The “dry powder” of bonds and the math behind rebalancing automate out the emotional mistakes.
      I’m admittedly more forgiving of the Bogleheads since I think there’s a reasonable balance between simplicity and achieving a good enough to reach your goals portfolio, although your critiques of international stocks are echoed by many folks I admire.

      1. CD I have a POV that is very quantitative based on statistics, Over the years I have become comfortable in that position as it fits with Stoic take on reality, all reality is present and all time is forward moving. You never step in the same river twice so behaving like this river is like the old misses the reality. To me the past is a bit of a mirage ensconced in your biochemistry. Of course I expect no one to look at life like this, but it does free me to experience change since that is all there is according to the stoics.

        My POV is on the perimeter (out here on the perimeter there are no stars, out here on the perimeter we is stoned immaculate. If someone walks away with a change in their POV then a little dab of light passes between us. I am not foolish enough to try to win, only offer something a bit different. I responded to big ERN and gave him my opinion about the failure of the small value tilt. I think it’s a number of things, momentum trading, and the squelching of creative destruction by the behemoths. The business model is not to start a company and grow it, its to start a company and sell out to Google and pocket the dough. A couple decades there were like 10K stocks now only 3K. You can’t have a robust small cap tilt if you have no small caps to tilt.

        RE boggleheads, I find the theory problematic and merely state my case. People are perfectly free to ignore me because like I said the point is not to win but to question.

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          Author

          Gasem,

          Your quant-heavy ideas reach my head with the cold, sudden fury of a divine messenger. I relish the your continued challenging and questioning in the pursuit of intellectual curiosity.

          Fondly,

          CD

  3. Naive diversification is one way to call it.
    In this particular post that’s intra portfolio diversification.
    It’s still within a porfolio. Even with GLD.
    It’s still “all in” financial stuff.
    That’s the ultimate in being financially naive and uneducated IMO.
    Uneducated does not mean stupid. Not at all.

    Then there’s NAIVE diversification.
    Still better that all financial instruments.
    That could include physical gold in a foreign jurisdiction, land at home and abroad, real estate at home and abroad, collectibles and art, and yes even BTC/LTC.
    etc..

    And then SOPHISTICATED.
    Where all of the above are weighted along different criteria like age, residence, political risk, knowledge of financial history, taste, hobbies. Changing the ownership, pyramiding ownership, crosscovering ownership, trusts foreign and domestic, etc…

    And then the SUPRA SOPHISTICATED aka the super rich.
    Where the assets are not bought but created. Magic money. Bank money. Out of thin air. Fractionally reserved.
    Liquidity events as “they” call it. Where billions and trillions just appear on a computer statement. And buy all the fake assets of the naive diversificators, either outright or (in a subtly evil manner) through dilution .
    The fiat dream of endless money, masters of the universe.

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