Investor Psychology Series Chapter 4: The Human Psyche and Diversification

These same behavioural issues become even more acute and more impactful for an investor’s total return when they impinge on an investor’s total assets.

Asset diversification was strongly advocated by Nobel Prize winning economist Harry Markowitz in his 1952 Modern Portfolio Theory. He stressed that a security should not be evaluated alone, but rather by how it affects the portfolio as a whole (i.e., rather than concentrating on individual securities, investors should consider their overall wealth more broadly and where a security fits).

We as investors know that diversification is a proven method of investing due to its ability to buffer the investor from bouts of volatility while also providing upside exposure to markets and assets in periods of windfall. Yet most investors miss out on the advantages of diversification due to human psyche bias that leads to adverse investment behaviours, these include the following:

Ringfencing

Although investors know they should look at their ‘whole’ portfolio, numerous studies show most tend to become hyper-focused on specific investments or investment classes in the portfolio and ignore others. This is particularly true when that investment or asset class confirms their ‘self-attribution’ bias (see chapter one).

This narrow focus ‘borders’ an investor’s thinking and ‘ringfences’ each investment inside the portfolio. The issue with ringfencing is that with each asset class being treated separately, the disposition effect (see chapter two) can take hold, leading to adverse investment decisions and the investor’s diversification being lost. It can also lead to a heightened sensitivity to loss, also explained in chapter two.

Ringfencing can be overcome by developing a wider focus i.e., looking at a security or asset class as a percentage of the whole portfolio rather than seeing it as an individual performer.

Familiarity bias

What is also true of the human psyche is that we gravitate to the familiar. In social settings we gravitate to familiar groups as we know the rules and can easily fit into the group’s constructs.

In behavioural finances this can manifest into investing in familiar investment classes and securities rather than truly diversifying into assets we need. For example, we know from an array of cross-country studies, investors will tend to invest in their own region, state, country or even their own industry of work as these are all familiar investment environments. This, however, can lead to sub-par diversification inside the portfolio, as the investor’s ‘home bias’ can lead to over-allocating to the familiar rather than the optimal allocation, leading to poor portfolio returns.

This point is particularly acute when looking at domestic to international equity investment. The recent annual ASX Pty. Ltd. survey of Australian retail investors and their investment habits shows that only 27 per cent of those surveyed have some international equities, this is up from 17 per cent in 2014. The survey also showed that of those that held international equities, their allocation as a percentage of their overall portfolio was only 2 per cent, highlighting that their fund allocation is skewed to the familiar domestic assets which will likely produce suboptimal performance.