Diversification bias: your portfolio may be riskier than you think

There's more to diversification than adding more stocks, and these biases are working against you.

Here’s the scariest statistic I’ve read in a while: In a 2015 survey of Australia's financial literacy, people were asked about 'diversification' as an investing principle. Some 60% of the 4,100 respondents ticked 'I haven't heard of this' or 'I have heard of this but don't really understand it'. Yikes.

If you’re reading this, you are probably in the minority who do understand the benefits of a diversified portfolio. Spreading your bets across several stocks reduces volatility and your exposure to company-specific risks. But, even for experienced investors, a few mental biases can creep up and your nest egg may suffer as a result.     

First among these is diversification bias, which is essentially our fear of focus. We value having options and put effort into keeping those options open – even when it is costly or pointless.

Diversification bias means that your portfolio is prone to gathering lots of small positions. The pain of selling too early sticks with us so, if you’re like most people, you may find it hard to sell out of positions completely.

For passive investors without the time or craving to research individual companies, the more diversified you are the better. We’re strong advocates of low-cost index funds that hold hundreds, if not thousands of stocks.

If you own the stocks directly, though, lots of small positions can drag on your portfolio by increasing brokerage costs. It also means that you have to spread your attention, making it difficult to know each company in depth.

If you’re confident in your ability and willing to do the homework, lots of diversification doesn’t make sense. Most investors would benefit from less activity and more selectivity.

We generally recommend a portfolio concentrated in 10–20 high-quality, undervalued companies. As Warren Buffett put it, ‘It’s crazy to put money into your 20th choice rather than your 1st choice ... If you have LeBron James on your team, don’t take him out of the game just to make room for someone else.’

Naïve diversification

While we naturally like to spread our money across different opportunities, we don’t always do it in ways that are useful.

Behavioural economist Richard Thaler split University of California employees into two groups and asked them how they would invest their retirement savings given the option of two mutual funds.

Group 1 was offered one mutual fund that invested only in stocks, and a second that invested only in bonds. Group 2 was offered a fund that invested only in stocks, with the other being a ‘balanced’ fund that had half stocks and half bonds.

As you might expect, Group 1 participants tended to divide their contributions evenly between the two funds. But the same was found for Group 2 – even though that would make them significantly more weighted towards stocks than the first group.

The experiment was a demonstration of naïve diversification and the ‘1/n heuristic’. We focus on the number of things in our portfolio, rather than their individual qualities.

The lesson here is that simply owning more stocks and funds doesn’t mean you are well diversified. Take a moment to think about your individual holdings, and whether they are in the same industry or are exposed to similar threats. Good diversification is about reducing risks, not adding stocks.

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