Under vs. Over Diversification

Tuesday, October 12th, 2010

Retiring and confidently spending your hard earned savings without the constant fear that you’re going to run out requires that you earn a certain rate of return on your investments.

However, that rate of return is different for everyone. It’s all based on your level of dependence on your Retirement Bucket™ (accumulated investments that you can tap into). And, of course, the size of your Retirement Bucket™.

Achieving the rate of return that you must earn is no easy task. If it was easy, then everyone would do it.

Unfortunately, as we’ve learned with the Dalbar Report, the average retiree investing in equity mutual funds earned 77% less than the S&P 500 Index over the last 20 years, and 90% less than the Barclays Bond Index.

Given these dismal results, the financial solvency of the average retiree is in serious jeopardy.

The question you must continuously ask yourself is why? What is the average retiree doing wrong?

In this Retirement Coach Strategy of the Week, we’re going to examine two more reasons why this dismal performance has occurred.

“Under” Diversification

Diversification is a huge contributor to long term investment performance and volatility.

Interestingly, over the last 21 years, I’ve witnessed it in spades on both sides of the coin.

Let’s begin with under-diversification.

There are a few examples of this that I see way too often. The most obvious one is holding large amounts of one stock, typically your employer’s stock.

Over the years, I’ve personally witnessed employees of many large companies, including GE, Lucent, Polaroid, AT&T, and Procter and Gamble all fall into this trap of believing that they’re sufficiently diversified because their company is a big, well known company.

Each one of them fell prey to this problem and suffered horrific consequences as a result.

Recently, I met with a couple who has 100% of their holdings in Hewlett Packard. Company stock purchased over the years in a stock purchase plan, and inside his 401(k).

Same exact issue for this couple. Complete reliance for their financial future all tied to one entity.

Example #2

The second example of under-diversification that I see, however, seems less obvious. And, that’s an overconcentration in one sector or one style of investing.

For example, from 1997 thru 2000, as tech stocks skyrocketed, the overwhelming majority of retirees pulled out of everything else they owned and loaded up in tech stocks or tech mutual funds.

What followed was so predictable. Technology driven NASDAQ stocks plummeted over 75%!

The problem with loading up in any one sector or idea is 100% correlation which means that all your investments end up moving in the same direction.

This feels wonderful when your sector rises. However, when it corrects and you’re sitting there holding everything in that sector, you’re in for a significant problem.

What so many retirees do is take a look at the performance of their investments. They sell those that didn’t perform as well last year, and double up and buy more of what did better.

The notion, of course, is that whatever just did well will continue to do well. That there’s some sort of “trend” that they’re going to miss out on.

This is a recipe for disaster and a huge contributor to why the average investor earned 77% less than the market index.

“Over” Diversification

While it’s not as common, a real problem that I see a lot is over-diversification.

What over-diversification represents is simply the inability to make choices.

Warren Buffet once said that, at birth, you should be given 20 chits so you could only hold 20 investments. No more and no less.

This would force you to have to make good decisions. In other words, “is this one of the twenty?”

Over-diversification, at its core, is the abandonment of this principle.

The best example I can give you is one I see often and that’s the person who goes out and buys the #1 fund on Money Magazine’s list each year.

If he repeats this process every year for the next 12 years, he’ll end up buying 12 different mutual funds because the chances of the same fund being #1 two years in a row are almost impossible.

While it appears that there’s intelligent diversification going on, in reality, what a portfolio built this way ends up being is just a very inefficient, and very expensive index fund.

And, it’s typically wrought with big gaps, and typically a huge amount of overlap and duplication, thus accomplishing the opposite of what was the intention in the first place.

Committed To Your Relaxing Retirement,

Jack Phelps
The Retirement Coach

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