Having a variety of investments has always been considered a sound portfolio practice because it ensures that when one investment declines, you’ve at least got a chance of having something else that gains.
But blindly following even a good rule of thumb can do more harm than good.
That’s what behavioral finance researchers at Morningstar and the University of Chicago found in a recent experiment.
They asked a sample of 3,622 people to allocate a hypothetical $10,000 among three actual exchange-traded funds that tracked Standard & Poor’s 500-stock index.
The three funds were essentially identical, except for fees: One ETF had an expense ratio of 0.40 percent, one charged 0.09 percent of assets, and the third charged 0.04 percent. Participants had all the information they needed to evaluate the funds.
Half of them were told they could choose just one fund; half were told they could allocate the money freely among all three funds.
The researchers discovered that when it comes to investment fees, diversification efforts can backfire.
About 47 percent of the first group chose the cheapest fund option — the correct choice, given the identical makeup of the funds and similar performance records.
But only 14 percent of investors with access to all three funds chose to put all of their money in the cheapest version.
On average, those who could allocate freely put 27 percent of their money in the most expensive ETF, 31 percent in the middle-cost ETF and 42 percent in the cheapest.
The results show that when given the option, investors put a sizable portion of their money into high-cost investments when nearly identical low-cost options are available.
“Investors are sensitive to fees, but an overreliance on diversification overrides that sensitivity,” says Morningstar behavioral scientist Ray Sin.
Diversification errors can be triggered by too many choices within a complex decision, the researchers say.
The researchers recommend that investment advisers take a cue from Costco and curate the choices they offer investors, similar to the way the retailer offers a limited selection of high-quality goods at reasonable prices.
Investors can curate their portfolios on their own by remembering that diversification is meant to give you exposure to different asset classes, such as stocks or bonds, or different sectors, industries or investment styles within those categories.
Start by determining what’s appropriate for your goals and ignoring the rest; a 30-year-old focused on growth does not have to sort through a lot of bond funds, for example.
And be discriminating within each category. For example, if you have more than one small-company growth stock fund, you’ve probably got too many.
Finally, if you’re choosing among substantially similar funds — nearly identical in the case of index funds — lower expenses should be the most important factor in your decision.
