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Financial Decoder: Season 2 Episode 1

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The more stocks you own, the more diversified you are, right? Not necessarily. There could be other factors—including your own built-in biases—holding you back from creating a truly diversified portfolio.

Two corrections for the broad market in 2018, coupled with bear markets in various segments, have many investors facing a decision: Do I have the right level of diversification in my portfolio, or do I need to make some changes? Many people simply aren’t diversified as well as they should be.

In this episode, Mark Riepe breaks down the ways your cognitive biases might be preventing you from building a truly diversified portfolio. Joining Mark is Omar Aguilar from Charles Schwab Investment Management. Mark and Omar discuss how you can tell if your portfolio isn’t diversified enough—and how you can change that.

  • You can read more about how diversification works in the 2008 study “Equity Portfolio Diversification” by William N. Goetzmann and Alok Kumar, which appeared in Review of Finance.
  • And Omar Aguilar further explores home country bias in investing in the article “The Comforts of Home.

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Financial Decoder is an original podcast from Charles Schwab.

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MARK RIEPE: In Shakespeare’s The Merchant of Venice, the merchant is a powerful and wealthy nobleman named Antonio. At the beginning of the play Antonio’s friends suggest to him that his depression is caused by financial problems. He replies, “Believe me, no, I thank my fortune for it. My ventures are not in one bottom trusted nor to one place, nor is my whole estate upon the fortune of this present year. Therefore, my merchandise makes me not sad.”

Obviously, acting isn’t my thing, so thank you for enduring that. The last time I publicly delivered a line from a play was when I stunned the audience with my definitive portrayal as snowflake number one in second grade. Anyway, “bottom” in Shakespeare’s time meant ship. As a wise merchant, Antonio has his business interests spread across multiple shipping lines, and he’s invested in multiple types of merchandise. This strategy allows him to weather a bad year, a sunken ship or a treacherous trading partner. 

What Shakespeare and Antonio understood was the power of diversification. After "buy low and sell high," it’s probably the oldest concept in investing. For many investors and for many businesses, it’s often a lesson learned the hard way. Perhaps you know someone who put the family fortune into a single stock holding or invested their nest egg in a piece of real estate. Stories like that often end poorly.

2018 was a rough year for investors. Two corrections for the broad stock market coupled with bear markets in various segments of the equity market had many investors facing a decision—“Do I have the right level of diversification in my portfolio, or do I need to make some changes?” My guess is that most people aren’t diversified as well as they should be, and in this episode we’ll dig into the biases and heuristics that might be preventing you from building a truly diversified portfolio.

I’m Mark Riepe, and this is Financial Decoder, an original podcast from Charles Schwab. On this podcast, we examine the cognitive and emotional biases that can influence your financial decisions and we offer strategies to help you mitigate those biases and improve your financial outcomes.

When it comes to diversification, there are two interrelated issues at play. The first is what I’ll call the “more is better” heuristic. This happens when you build a portfolio thinking that the more securities you own, the more diversified you are. Like many heuristics, there’s a certain logic behind this. If you buy one stock, there’s a fair amount of volatility associated with that. If you spread your money across two randomly selected stocks, the odds are that the combination of the two will be less volatile than the first stock by itself. As you add more stocks, three, four or 100, the volatility of the portfolio tends to drop. In fact, you can find many academic studies[1] that show how portfolio risk decreases as the number of stocks in a portfolio increases. The problem with simply buying more stocks is that it doesn’t take into account how correlated the stocks are with one another. For example, if you buy stock in General Motors, and then Ford, and then Toyota, you’re getting some diversification, but not nearly as much as you would get if you added stocks in several completely unrelated industries. This isn’t just a theoretical concern.

One study[2] that examined the actual portfolios of individual investors found that the returns of the stocks they held had a higher than average correlation with one another, and because of that the portfolios were more volatile.

Let me take a step back and unpack that a little bit. In this context, correlation refers to how the individual stocks move with respect to one another. If two stocks have prices that tend to move up and down together, that means there’s a positive correlation between them. If their prices tend to move in the opposite direction, then there’s a negative correlation. What this study found was that the stocks in the portfolios of these investors tended to be more correlated with each other than individual stocks tend to be, and because of that, the returns of the portfolios were more volatile.

The second problem is known as the 1 over N heuristic. The idea is that you take a group of N investments and spread your money equally across them.[3] Let’s say N equals three. That means you put one third of your money into each of three investments. This approach to diversification has been around for a really long time. The Babylonian Talmud was a collection of rabbinic opinions that were handed down orally for centuries before being written down in about the year 500. One of those rabbis was named Isaac Bar Aha[4], and he said that N should equal 3, with one third of your money invested into a business, one third into land and one third held in reserve.

This rule has a certain logic to it. First of all, you’re spreading your money around, and that’s a good thing. You’re reducing the risk that you’ll have a huge stake in the worst-performing investment. You’re also guaranteeing that you’ll have a stake in the best-performing investment. The problems of course are that you can’t really pick your level of risk. In other words, it may make sense for some people to pick mostly conservative investments, while others should choose mostly aggressive investments. That’s hard to do with the strict implementation of the 1 over N rule because you’re dependent on the universe that you can choose from. If N equals 5 and the only choices are U.S. large-cap stocks, U.S. small-cap stocks, high-dividend-paying stocks, emerging-market stocks and gold, you’re going to end up with a pretty aggressive portfolio no matter what.

Despite the inch-deep logic that supports the 1 over N rule, I suspect the real story behind its popularity has to do with choice overload.

It’s rare that I meet anyone who isn’t busy, and one characteristic of busy people is that they’re bombarded with decisions that need to be made in a short period of time. We all know it’s hard to make an optimal decision under those circumstances, and that’s especially true if the decision involves a topic on which the busy person isn’t an expert. Let’s face it, investing isn’t most people’s passion, and financial literacy isn’t especially high in the United States, as numerous studies[5] have shown. So it’s not surprising that when presented with a menu of investment options in, for example, a 401(k) plan, many people will choose to invest about the same amount in each of the choices presented.

This isn’t just speculation. A real-world example of the 1 over N approach comes from a study[6] of 401(K) plan investors. In the interest of time, I won’t go through the full results of the study because one anecdote from the authors tells you all you need to know. In the course of their work, they found a retirement plan with six investment options, five of which were stock funds. Seventy-five percent of the money in the plan was invested in stock funds, almost exactly what you would expect if all the plan participants were following the 1 over N rule. Another plan from a different employer had five investment options. Only one was a stock fund. The others were bond funds. In this plan, only 34% of the money was in stocks. There may be rational reasons for why the employees at the two employers ended up with, on average, very different portfolios. As a test, the authors asked the employees from the firm with the conservative lineup to look at the investment lineup at the other firm and decide how they would invest if it represented the options available to them. Not surprisingly, those employees allocated their money in a way that shifted their portfolio from mostly bonds to mostly stocks. It appears as if the employees were simply looking at the choices and then spreading their money across the options willy-nilly, not really paying attention to what those choices were.

The good news is that the companies who sponsor 401(k) plans have observed this behavior and have taken steps to improve their employees’ decision-making. For more details on the help that many 401(k) plan sponsors and providers offer, listen to our previous episode, “What Should You Do With Your 401(k)?”

Investors following the more is better approach or 1 over N rule probably understand the importance of diversification, but they may not realize that there are several other biases that work against them, and everyone else for that matter, when trying to build and maintain a diversified portfolio. Think of these biases as creating temptations that are always pushing you into creating a portfolio that is more concentrated than may be prudent.

The first one of those biases is overconfidence. At its core, diversification is an act of humility. After all, if you had a crystal ball that foretold the future, the best investing strategy would be to invest in whatever will have the highest return over your investing timeframe. Diversification is an admission that you don’t know what’s going to happen in the future. You may have a sense as to what opportunities seem more attractive than others, but you don’t really know, and there are certainly no guarantees. Diversification, therefore, makes sense in order to control the level of risk in your portfolio.

But humility isn’t always easy to come by. Many studies have shown that most people tend to be overconfident, and one aspect of the overconfident is that they think they have a better handle on what the future will bring than they actually do. Because they believe they have a good handle on the future, overconfident investors downplay the need for diversification. But this overconfidence is unwarranted. For example, one study[7] looked at the actual portfolios of individual investors over about a five-year period. For each investor, the authors created a portfolio that had the same level of volatility or risk using the S&P 500® Index and cash. This matching portfolio served as a benchmark. They then compared the actual returns of the investor to the benchmark that was customized for that investor. About 90% of the investors trailed their benchmark.

A second bias is the familiarity bias. The portfolios of many individuals tend not to be representative of the overall market. Instead, many portfolios tend to be tilted towards securities with which the investor has some familiarity. One striking example of this occurs in 401(k) plans. In plans where the option exists to invest in the stock of their employer, 10% of employees put over 50% of their assets[8] into the stock of the company where they work.

This tendency to invest in the familiar takes many subtler forms, too. The home country bias is one manifestation of the familiarity bias. It’s the tendency to over-invest in stocks from your own country. For example, the United States has a big stock market. Its market capitalization, or the price of all companies multiplied by the number of shares traded on an exchange, is about $32 trillion. That’s a lot of money, but it’s only 38% of the total market cap of the entire world.[9]

What if the U.S. investor invested only in stocks headquartered in a handful of big states? There are a lot of opportunities outside those states that the investor would miss. The same line of reasoning applies to an investor who only focuses on the U.S. and ignores the opportunities in the rest of the world. While it’s true that U.S. investors don’t entirely ignore investments in the rest of the world, they aren’t exactly top of mind either. For example, Baby Boomers only have about 16%[10] of their portfolios invested outside the United States.

A third bias is saliency. One of my favorite titles in the academic literature is “All That Glitters.”[11] This study documents how the portfolios of individual investors tend to be dominated by stocks that have flashy characteristics. The reason for this goes back to saliency, a bias we discussed in the episode about how much risk to take with your bond portfolio. We all have a limited amount of time to devote to investing. If you’re looking to buy something for your portfolio, there are tens of thousands of choices you could make, but you don’t have tens of thousands of hours to study all of the choices. By necessity, we all try to winnow-down the pool of candidates quickly. One way to do that is by focusing on what I’ll call shiny objects. For those who invest in individual stocks, these are stocks that have been in the news, or whose price is skyrocketing, or have had vivid stories associated with them. For mutual funds, this could mean those funds which have recently dominated the performance charts. In a study using data on individual investors from multiple brokerage firms, the authors found that investors are far more likely to buy what they call attention-grabbing stocks.

The connection to the topic of this episode is that if you only invest in shiny objects, I believe that you’re less likely to build a diversified portfolio because not all stocks are inherently as attention-grabbing as others, and the same applies to mutual funds. As a result, your portfolio could potentially become tilted towards certain sectors, industries or types of funds.

To help explain how these biases can influence diversification, Omar Aguilar has joined me again. Omar is the chief investment officer for equities at Charles Schwab Investment Management. Omar, thanks for being on the show.

OMAR AGUILAR: Hi, Mark.

MARK: So your last appearance on the show generated a lot of interest and I’m glad that you’re joining us again to talk about diversification. We’ve already covered some of the heuristics that people use when diversifying, as well as some of the biases that get in the way of good diversification, but we haven’t really explained what somebody should actually be doing. So let’s say you’re starting from scratch. What’s your process for building a diversified portfolio?

OMAR: Great question, Mark. I get these questions from my own team. And, you know, I have a group of professional portfolio managers, analysts and traders that, you know, their daily job is to basically figure out diversification. And it’s … diversification is one of those concepts that is very hard to touch, and it’s very hard to know what that really means: “diversification.” So what we have established in order for us to center and talk about the same things is to create what we call a three-step process.

The first piece is, define and remember the investment objective. So what is it we’re trying to attain? Usually, you know, you start by looking at what is the ultimate client experience, or what is it that you’re trying to do with these particular investments, and what are you willing to do to get to those investments? So defining risk tolerance, defining what are you willing to do in order to achieve those investments, is step number one.

Step number two is to try to look at all possible vehicles or asset classes that you can use in order for you to figure out the strategy. So you can have a series of hundreds, even thousands, of potential options that you can have to pick in order for you to achieve those investments. The main part of those is that you have to understand that each one of those potential vehicles, they come with characteristics. Each one of those vehicles or each one of those asset classes have different things that they are not the same; they have to be particularly different. And usually we use history to try to figure out how those characteristics, you know, eventually move.

And the last piece is, the third part of the process includes making sure that we have defined a process that is very systematic in how to evaluate whether or not we’re on the right track.

So I’m going to give you just a little bit of an example, especially because I like basketball. Basketball is a perfect example on how diversification works. If you think about the three-step process I’ve just laid out, think about yourself as being the coach of a basketball team. You obviously know that you’re going to have guards, you’re going to have forwards, and, for the most part, people have a center. Well, you start by saying my strategy, my investment objective, or my objective in basketball is going to be to win. I don’t think anybody wants to lose. Everybody is trying to define how to win. And you’re trying to figure out what is going to be the combination of these positions that allows you to win.

Then you’re going to look at all the potential, you know, students or athletes that you have to figure out how you’re going to put them in positions. Obviously, the tallest guys will probably going to be in the center. That’s sort of what normally happens. The guys that are good shooters, they’re going to be your guards. The ones that are more talented in terms of being physically fit, they’re going to be your forwards. Usually, those characteristics are the ones that you want to have in order to select who is going to be in the starting lineup. So that’s a step number two.

And then the final piece is going to be as you start playing games, as you start doing practices, you’re going to figure out how these things all work together. But you need to evaluate, and at the end of the day figure out, did the strategies work? Everything is moving according to what I had in mind, and, therefore, keeping this feedback loop all together in a systematic way. Evaluate it after every practice, evaluate it after every game.

So that’s sort of a way for us to, you know, continue to do that every time that we invest money on behalf of clients.

MARK: That’s a great example. And I think bringing it back to kind of an investing context, we’ve talked about on prior episodes of the importance of having a plan, and setting your objectives and making sure your portfolio matches up with those objectives. And I think on a future episode we’re going to be talking about setting your risk tolerance.

So let’s talk about the second piece of that, figuring out the interrelationship between all the different pieces in the portfolio. We talked earlier about correlation and making sure you want to avoid assets that have a high correlation with one another. Is that pretty much what you’re talking about here at the asset class level?

OMAR: Absolutely. I mean the idea of diversification is understanding that each one of those vehicles or asset classes will play a different role in the strategy. They are designed, and the concept of diversification is designed, that in any particular market environment, you’re going to have one of these asset classes that is going to be working for you. The other ones may not, and in many cases it could take years for all of these asset classes to potentially have a role in the portfolio. But the reason why you do that is because of correlations, because of these relationships among asset classes, that as long as they’re not perfect, they will provide some benefit.

Now, you know, again, if I go back to the analogy that I have on basketball, it is the same thing you normally see, you know, how two players can actually work very well with each other. Sometimes you don’t even understand why, but historically it is because a player knows exactly where the other player is, and depending on the opponent, they can actually play off each other very well. That’s the same concept that happens in investments. You don’t know what the market is going to do to you. You don’t know what kind of environment you’re going to face, but you know that in some cases there’s going to be fixed income assets that will help you when there is a lot of volatility in equities. There will be times where the market is growing that obviously you’re going to, you know, have the benefits of having equity exposure or more risky assets. Those things are happening in many cases. If you think about, you know, the environment today, 10 years of a bull market, that’s when you want risky assets. In many cases, you have had a bull market in bonds that also allows you to do that. It’s really just that relationships that over time, you know, should benefit your strategy.

MARK: So pretty much as part of your process you’ve identified the role of every investment in your portfolios and how that ties back to the objectives of the portfolio.

OMAR: Exactly. The idea is that, you know, as you think about what needs to happen and thinking about the potential, you know, opponents, and I’m thinking about, again, you know, going back to my analogy on basketball, if you think about it, you never know what the other team is going to be. You never know what exactly is going to be the strategy of the other coach, but you know how you’re going to position your players once you see what is ahead of you. And I think just knowing that, you know, what is the role of each one of those positions is actually critical before you even start the game. That’s what you have control.

So understanding what you have control, which means what is the role of equities, what is the role of fixed income, what is the role of commodities, what is the role of cash, that is critical before you even start investing.

MARK: So let’s talk a little bit more about the third part of your process, the evaluating and monitoring. So what does that look like under real-world conditions?

OMAR: Well, that’s probably the most, you know, critical part of this process because diversification never ends, you’re never finished with diversification, because these dynamic relationships or correlations, they’re changing all the time. There are periods of time where, you know, history doesn’t repeat, and all of a sudden you realize that what you thought it was going to be, uncorrelated or negatively correlated, it turns out to be correlated. In fact, most of what is called the, you know, outliers, or most of the time where you have significant market events, it is because correlations basically work against you or against what you thought it was. It is rare, but when it happens, it tends to be very painful.

So the role of what we do in terms of monitoring is understanding if what you plan is actually working as designed. So think about this first. If you’re starting a game and all of a sudden you realize that your guards are not shooting, well, something is not working. There is something that you may be missing that you may have to adjust. At the same time, if you all of a sudden realize that your forwards are actually just the ones that are scoring all the points, then you realize that maybe it is the area where you need to put a little more attention.

So understanding that at some point during this transition, you know, there will be situations where the historical correlations are not going to work the same they were before, it is a critical part of evaluating whether the strategy is providing you the diversification that you sought for each strategy.

MARK: So the worst case scenario is you have these elements in your portfolio, you thought one was going to zig when the other one was going to zag, but during certain quarters, certain months, that may not happen. And so that kind of gets back to what you were talking about, correlations can work against you under rare market circumstances.

OMAR: Absolutely. And I think, to me, the key component, Mark, is that you have to realize that these events will happen. And I think it is important for you to remember that, you know, history and the relationship between asset classes in the long run works. Diversification works, but it’s usually those periods of time when it’s the most painful that you need to continue with your process. A big part of establishing this process is realizing that, yes, the worst case scenario will probably happen. Low probability and very infrequent, but, yes, there will be a situation when all correlations go to one, or meaning every single asset class will work in a weird way. But you also have to remember that in the long run, those correlations tend to go back to what the history tells us.

MARK: So there’s a school of thought that says you should just focus on your best ideas, and if you deviate from your best ideas you’re just going to end up with mediocre performance. That’s not what you’re doing at Charles Schwab Investment Management. Your portfolios tend to be more diversified than most. So why haven’t you gone that route of concentrating your portfolios?

OMAR: That’s a great question because, yes, there’s a school of thought that thinks you should only invest in your best ideas. So at Charles Schwab Investment Management, it’s not like we go with our bad ideas. You know, what we actually try to do is understanding that, you know, there is a lot of opportunities for increased diversification, and diversification leads to better risk-adjusted returns. So we understand by trying to scan all the possible, you know, options that we have, you know, what are the best risk/return trade-offs that we can put together in a strategy to maximize the likelihood that we’re going to achieve the investment objectives?  If you only focus on your ideas that you have or one person or one group of ideas, the likelihood that you’re going to achieve your investment objectives is going to go lower, because most of the time those ideas will be biased, just like we discussed, the human biases, you know, they will be biased toward certain things that happens to a human being. They are not necessarily properly looking at all possible options you have. Going back to basketball, imagine if somebody tells you that you have all possible NBA players available for you to pick from. Well, that’s awesome because then you can actually really create and maximize the dream team. And that’s basically the reason why the U.S. wins, you know, gold medals every Olympics, because you have the dream team.

MARK: So earlier we talked about the familiarity bias. In fact, people are often advised to, you know, go ahead and invest in what you know. So that makes sense to a certain point, but I’m under the impression that that also can lead to less diversification or less diversified portfolios. What are your thoughts on that?

OMAR: Well, I think it’s not just that it provides less diversification, Mark, but it also increases the risk. You know, I think this familiarity bias, understand what you are comfortable investing, at some point, you know, leads you to not necessarily deviating away from there, even when things are not working. You know, a big part of diversification is understanding that if things are just either too good to be true or if things are just heavily concentrated in your results, just a few of your ideas, that means you’re not properly diversified, because at some point those things are not going to work. The market is very good at telling us, you know, what we don’t know. And I think concentrating everything in just a few familiar ideas, at some point it will not work, and that’s the part where you realize that things were not properly diversified.

MARK: So let’s switch perspective a little bit then and think about this from the standpoint not of a person who is constructing a portfolio for the first time, but someone who already has a portfolio. What are some of the telltale signs that it may not be as diversified as they think they have, and they’re really facing a decision about whether they should do something different?

OMAR: Yeah, and it’s almost like, you know, going to the doctor, and it’s a big component of understanding if everything that you have is working properly. And, again, going back to my analogy on basketball is if you realize after halftime that all your points are coming from one player, you’ll realize that at some point the other team is going to just try to guard that player, and you may not win the game. 

So at the beginning of the process, I described investment objectives. And, you know, the second part of the process is what is the role of each one of your investment vehicles or asset classes? While the constant evaluation as you have a strategy is to understand where the sources of returns are coming from. If you realize that either the positives or the negatives are coming from one, or two or just a few of your investment vehicles or asset classes, then that’s when you realize that things may not be properly diversified. You would like to spread the returns across multiple of your investment vehicles or asset classes, so that each one of them has a role that not necessarily dominate at any given time.

So that’s the big part of, you know, trying to be less concentrated, and, again, concentration usually leads to more volatility and more risk. By creating diversification, you spread out the points among all your team players, so that then you have more chances to potentially collectively achieve your investment objectives.

MARK: So it really kind of ties into step three of your process, which is, you know, the evaluation and the monitoring. When you get your account statement, don’t just focus on the rate of return you got that year, that month, that quarter, but, you know, what was contributing to those returns?

OMAR: Absolutely. And you know, first of all, you want to make sure that it’s spread out across, you know, all your investments. But, second of all, you want to make sure that those make sense. So if you have a market that is going up, you want to make sure that those growth assets that you have are the ones that are contributing. If you think it’s a market that is going down or is emphasizing yield, you want to make sure your fixed income assets are contributing what you expected to have. It’s all about making sure that each one of these investments is doing what they’re supposed to be doing.

MARK: The last time you were here, we talked a little bit about the endowment effect, the fact that people can sometimes be reluctant to part with things that they already own, that they place a high value on. How do you counteract that, because that’s also going to introduce some bias into the portfolio?

OMAR: Yes, and, you know, that is very typical, and, you know, it happens to everybody. That’s a very typical human behavior and bias that happens to professional portfolio managers and, you know, professional investors. The endowment effect is very typical, especially when things are working. If you realize that, you know, things are moving well, if you have invested in technology for the last few years, you realize that things are going well, and, you know, things, it’s very hard for people to let go. That’s the reason we established the process. If you look at the third part of the process, when you realize and look back at the last, you know, two years, and realize that the majority of the performance is coming for just a certain portion of that portfolio, that’s a clear indication that you need to rebalance, and that’s a clear indication that you need to go back to the original targets that you set up for your strategy.

So the endowment effect, it is something that is very hard to do unless you have clear defined rules of a system that allows you to rebalance back to the original role of each one of those pieces. You know, I always learn a lot from looking at these coaches. Where do you see there is a player that is scoring, and has the hot hand, and continues to do well, and the good coaches will take that player out to just give him rest. And you, as a fan, you don’t understand why you do that. The guy is hot. The guy is doing very well. Well, the reason is because you realize that that at some point will end, and you want to give him a break, so that when he comes back, it will actually continue to play that way. The same thing happens with the endowment effect. You follow a process, you follow your rules, and that allows you to mitigate that as much as you can.

MARK: All right, last question, Omar. Diversification is important, but it isn’t a guarantee against losses. Why is that, and what can you do about it?

OMAR: Excellent question, Mark. First of all, you have to define what losses mean. Is it individual position losses relative to the investment strategy or portfolio losses? If you’re properly diversified, you should actually have positions that will have losses. The idea of this, as we were describing before, is that each one of your positions will have a different role in the strategy, and at any given point in time, some of these individual positions will actually have losses. However, diversification will help you, that in the long run you will have a bigger probability of achieving your investment objectives. That’s the difference. The difference is that diversification will maximize the likelihood of achieving your goals, where individual position losses will be part of the process, because that’s what diversification gives you. There will be periods of time in a bull market where your fixed income allocations will be at losses, there will be times when the market is down that your equity positions will be losses, but in the long run, because they are all working together, you will actually be closer to your investment objectives.

MARK: And that’s why you’ve got to focus on what the entire portfolio as a unit is doing, as opposed to getting too obsessed about what the individual positions are doing.

OMAR: That’s correct.

MARK: Great. Thanks for dropping by, Omar.

OMAR: Thank you very much.

MARK: The financial mistakes that people make are sometimes caused by a lack of financial literacy or knowledge about a certain product or investment, but at other times, the mistakes simply stem from built-in psychological biases we all have, like overconfidence or paying too much attention to what’s familiar to us. So let me wrap up with a few tips.

First, you can achieve diversification inexpensively. If you’re just looking for exposure to lots of asset classes or to broad exposure within a single asset class, buying low-cost index funds may allow you to accomplish both types of diversification. They won’t allow you to beat the market, but you get access to a broad range of markets for a low fee. If you prefer actively managed funds, that’s OK, but in your quest to diversify don’t make the mistake of investing in so many actively managed funds that you’ve effectively ended up buying the same securities as an index fund, but with the downside of paying much higher management fees.

The second tip is to be on the lookout for hidden correlations. The essence of diversification is to own some things that zig when the rest of the portfolio zags. Appearances can be deceptive, though. For example, you might own two stocks in different industries and think that they will behave differently. However, if both stocks are highly sensitive to changes in interest rates, then they may very well behave similarly. Another condition to watch out for is stocks that are codependent on each other. For example, a company that is highly dependent on another company to buy its products may find its stock price moving closely with the other firm. I wish there was an easy answer for how to track this problem in your portfolio, but there isn’t. If doing this kind of analysis doesn’t sound like fun, then that’s why mutual funds and exchange traded funds were invented, to give individuals a chance to benefit from investing in a diversified fashion without having to do all of the work themselves.

My third and final tip is to be strategic and not transactional with your portfolio. When it comes to diversification, one of the real-world difficulties that individuals face is that they’re usually engaging with their investments only on a sporadic basis, and that’s often when they have some new money to put into the portfolio or if they need to take some money out for some reason. They have a transactional relationship with their portfolio, and by that I mean they only pay attention when they have a transaction to make or a trade that they want to do. That’s understandable, but there are good reasons to believe that that approach works against diversification.

Let’s imagine you get an annual bonus from your employer—some of it you spend, some of it goes to taxes, and you prudently decide to invest the rest. You’re busy, so you want to get this done with as soon as you can. How are you going to invest it? An investment that’s done well recently? An investment that’s been in the news? An investment that’s in the same industry where you work? All of those are motivations that work against building a diversified portfolio. When you think transactionally about your portfolio, you’re adopting a narrow frame of reference and only thinking about the trade you’re about to do, which leaves you prone to decision-making errors. Contrast that with the investor who takes the time to look at their entire portfolio and make sure that the transaction they’re about to execute makes sense given the overall goals of the portfolio. Before you make that next trade, pause for a second.

Don’t just look at what you’re about to buy or sell in isolation. Think instead about how the trade will affect the rest of your portfolio. Are you investing in something that’s just like everything else you already own? If you sell something, does that sale make your portfolio vulnerable to some sort of risk? These are the kinds of questions you have to stop and ask yourself if you want to stay the course with diversification.

If you’re looking to start investing with a diversified portfolio, Schwab’s automated portfolios of low cost ETFs can be a convenient place to start your search. Check them out at Schwab.com/AutomatedInvesting.

If you would like to share your thoughts and ideas on the direction of the show, and give us any feedback, please take the survey available at Schwab.com/Survey to have your say. I’ve also put a link in the show notes to that survey.

Thanks for listening. If you’ve enjoyed this episode, consider leaving us a review on Apple podcast or your favorite listening app. It helps others discover the show. For important disclosures and a transcript, see the show notes and Schwab.com/FinancialDecoder.

 

[1] Meir Statman, “How Many Stocks Make a Diversified Portfolio?” Journal of Financial and Quantitative Analysis, September 1987.

[2] William N. Goetzmann and Alok Kumar, “Equity Portfolio Diversification,” Review of Finance, 2008, pp. 443-444.

[4] Shlomo Benartzi and Richard H. Thaler, “Naive Diversification Strategies in Defined Contribution Savings Plans,” American Economic Review, March 2001, p. 79

[5] Annamaria Lusardi and OIivia S. Mitchell, “The Economic Importance of Financial Literacy: Theory and Evidence,” Journal of Economic Literature, March 2014, pp. 5-44.

[6] Shlomo Benartzi and Richard H. Thaler, “Naive Diversification Strategies in Defined Contribution Savings Plans,” American Economic Review, March 2001, pp. 79-98.

[7] William N. Goetzmann and Alok Kumar, “Equity Portfolio Diversification,” Review of Finance, 2008, pp. 433-463.

[8] Jack VanDerhei, Sarah Holden, Luis Alonso, and Steven Bass, “401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2016,” Employee Benefit Research Institute, Issue Brief No. 458, September 10, 2018, page 35.

[9] 2019 Market Outlook: Trends in Capital Markets, SIFMA.

[10] Source: Omar Aguilar, “The Comforts of Home,” Charles Schwab Investment Management, Winter 2017.

[11] Bard M. Barber and Terrance Odean, “All That Glitters: The Effect of Attention and News on the Buying Behavior of Individual and Institutional Investors,” Review of Financial Studies, March 2008, pp. 785-818.

Important Disclosures

individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Correlation is a statistical measure of how two investments have historically moved in relation to each other, and ranges from -1 to +1. A correlation of 1 indicates a perfect positive correlation, while a correlation of -1 indicates a perfect negative correlation. A correlation of zero means the assets are not correlated.

Diversification and asset allocation strategies do not ensure a profit and cannot protect against losses in a declining market.

International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed‐income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors

Investing involves risk including loss of principal.

Hypothetical examples are for illustrative purposes only and are not intended to represent the past or future performance of any specific investment.

Past performance is no guarantee of future results.

Apple Podcasts and the Apple logo are trademarks of Apple Inc., registered in the U.S. and other countries.

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