From None to Too Much, How Much Diversification is Just Right?
This article discusses strategies 401(k) plan participants use to concentrate or diversify their assets, discussing one concentration strategy and three diversification strategies.
- 100% in a single stock
- Investing in a single fund
- Investing equally across all choices
- Investing in a portfolio from the efficient frontier
Before evaluating each strategy, it is important to establish what diversification is and how diversifying optimally will help your savings grow.
What is diversification? Spreading your bets as much as necessary
Since investing entails uncertainty about the future, you should not concentrate your savings. Instead you should invest in a mix of asset classes, spreading your bets across domestic and international assets and including a mix of stocks and bonds.
Centuries before Dr. Harry Markowitz described the mathematics that link risk with expected return, the concept of diversification to reduce uncertainty was well understood and used by insurers. An insurer can forecast with great accuracy its expected claims in a year, even though it CANNOT predict exactly which customers will make a claim. Because it reduces the uncertainty about their underwriting risks, diversification permits insurers to plan. Diversification transforms lots of individual bets from so many risky gambles into a profitable business strategy and permits a whole industry to exist and thrive.
The same concept of diversification permitting you to plan applies when you save in your retirement plan. Regardless of whether the market goes up or down, some assets will perform better, some worse. Your 401(k)-diversification strategy should remove any need to guess about which assets will go up or down. By diversifying, you or your advisor will be able to make reasonable plans based on expectations about your retirement assets and income and adjust your course according to your long-term goals.
100% in a Single Stock: A Risky Gamble
Corporate 401(k) plans commonly offer their own common stock as one of the investment options of the plan. The risk faced by an employee concentrating her 401(k) savings into company stock is a double whammy: if the company fails she could lose their job AND her retirement savings. Such a catastrophe struck employees of Enron and WorldCom in the early 2000s. When you read about a company filing for bankruptcy protection, know that its employees might also be experiencing a similar painful scenario. Beware the double whammy!
Just how much of a gamble individual stocks can be was documented by Hendrik Bessembinder, the Francis J. and Mary B. Labriola Professor of Competitive Business at Arizona State University. Bessembinder showed that, over their lifetime, most common stocks did not even outperform cash: “While the overall US stock market has handily outperformed Treasury bills in the long run, most individual common stocks have not.”[i] His paper caused a stir because of a seeming paradox: while individual stocks on average have been poor investments, the stock market as a whole has been a great investment, thanks to diversification.
Investing in a single fund or asset class: Under-diversified
At a less painful scale, too little diversification can also mean too few asset classes. When GuidedChoice gets the chance to see what do-it-yourself (DIY) investors hold in their 401(k) accounts, often they appear to hold too few asset classes. Many DIY savers hold only a single asset class – perhaps an S&P 500 Index fund or a Small Cap fund. While these savers are much better diversified than those who invest in only a single stock, they could diversify even better.
Imagine a fund of 150 stocks, with expected return 8% and standard deviation 25%. Formula 1 tells us we should expect it to compound at 4.9%. For that level of expected return, you can do better.
Allocating equally across available funds: Unnecessary and expensive
One understandable approach 401(k) participants have historically taken is to allocate equally to all available investment choices[ii]. This approach is known as 1/N (because it calls for allocating equally among the N options available).
This method has two problems. First, if the menu includes index funds, many of the other funds are redundant. If you looked under the hood at the non-index funds, chances are their holdings are also held by the index funds. This surprises some people, especially when it comes to Real Estate Investment Trust (REIT) funds. If your plan includes a REIT fund and a Small Cap index fund, chances are most of the REIT fund’s holdings are either in the Small Cap index fund or the Large Cap index fund. Second, those narrower funds probably charge higher fees, MUCH higher fees. Not only are you investing in more of what you could already have in the index funds, you are paying for the privilege.
 We don’t know what other assets they might hold elsewhere, so it’s possible in aggregate across other portfolios they might be sufficiently diversified.
Optimal diversification: The highest expected growth for the appropriate level of risk
GuidedChoice uses investment portfolio math to find the right mix of funds from your plan’s menu for every feasible level of expected return. Our investment team also knows how to write computer code, so they wrote software that applies this portfolio math. It allows us to use the funds on your menu to identify what combination of funds is the right mix for you. The “right mix” is the one that has the best trade-off between expected return and risk for your situation. Depending on the fund menu, the right mix might contain anywhere from two to fifteen funds.
Recommendation: Diversify optimally
Every person’s situation is unique and might call for a slightly different recommendation. Asset allocations are best decided as part of an integrated solution including the decision how much to save and when to retire.
If you don’t know the difference between stocks and bonds, chances are you should seek advice from professionals, whether means financial advisors or a digital retirement advisor like Guided Choice. Not only will we help you decide how much to save, when to retire, and how to allocate your assets, we can also help with your company stock options, if you have them.
[i] Bessembinder, Hendrik. “Do Stocks Outperform Treasury Bills?” Journal of Financial Economics, September 2018 (Vol 129, Issue 3).
[ii] Benartzi, Shlomo, and Thaler, Richard. “Naive Diversification Strategies in Defined Contribution Saving Plans,” American Economic Review, March 2001 (Vol 91, Issue 1).