When Diversification Backfires
Your investment plan lineup is not a buffet table--the dangers of naïve diversification.
Diversification is the key to any successful portfolio, and for good reason--a well-diversified portfolio can help an investor weather through the most turbulent markets. However, there are times when the general principle of diversification can work against investors. For example, the prevalence of mixed target-fund investors is a continuing concern for financial professionals. Despite the fact that target-date funds were designed to offer a pre-made, diversified solution for investors, some investors continue to spread out their assets to avoid “putting all their eggs in one basket.”
How can a well-meaning financial mantra--don’t put all your eggs in one basket--lead to such misguided decisions? Well, because we are human. When we are overwhelmed by a decision and aren’t quite sure what to do, our minds may start taking shortcuts. One of these shortcuts is naïve diversification, where we choose a little bit of each option to spread out our risk. When we’re facing an overloaded buffet table, this can be a great strategy. Serving ourselves a bit of each food option will ensure that we don’t miss out on anything. However, in investing, this shortcut can get us into trouble. Our research finds that a remarkable 86% of investors do what seems like diversification--but actually causes them to incur fees that directly undercut their returns.