Diversification 201: Implications of Diversification for Investor Behavior

by Rich Weiss
Senior Vice President and Senior Portfolio Manager,
American Century Investments

Weekly Market Update,

In this issue of Weekly Market Update, we present the latest installment in our occasional series on diversification. Here we look at diversification as a tool to help address many classic investor failings identified by the science of behavioral finance.

Earlier, in Diversification 101, we explained the rationale behind diversification and how it can be used as a framework for structuring a portfolio to help manage risk and maximize risk-adjusted performance. We also provided an Introduction to Alternative Investments meant to highlight the broad types of alternative strategies that can be used to diversify a traditional balanced portfolio of stocks and bonds. In future months we’ll address such topics as the state of diversification in a post-Financial Crisis world, and when and what types of diversification strategies make the most sense.

Investors Behaving Badly Better

One intriguing aspect of diversification is that it is born of modern portfolio theory, which assumes that the market is composed entirely of dispassionate, rational actors. In practice, however, investor behavior tends to be anything but rational and utility maximizing. This has given rise to an entirely new field of research termed “behavioral finance.”

The tension between efficient market and behavioral finance theorists makes for one of the enduring debates in financial and academic circles. But one thing they can both agree on is the tremendous benefit of diversification for investors—modern portfolio theorists because it creates more “efficient” portfolios; behavioralists because it puts structure around investor decisions and can help reduce the frequency and magnitude of mistakes. “Efficiency” in investing terms is defined as maximizing return for a given level of risk, and that investors can effect change in their portfolios’ risk-and-return profile by adding or subtracting uncorrelated assets to their portfolios.

In this regard, it’s instructive to look at market research firm DALBAR’s 2012 Quantitative Analysis of Investor Behavior. DALBAR devotes a portion of its new report to nine key behavioral errors, highlighting ways in which investors behave irrationally consistently and repeatedly over time. Behavioral finance topics in general, and DALBAR’s report specifically, make for fascinating reading. The biases they highlight influence investor behavior in a number of important ways. Here let’s focus on just one behavior—poorly timed buy and sell decisions—and look at how diversification can help mitigate the negative impact on investor performance over time.

Abandonment Rates

One well known investor sell mistake is to react badly to market events, eliminating equity investments and moving entirely to cash, effectively abandoning their investment strategy. Studies of investor behavior refer to this as the “abandonment rate,” or proportion of investors that simply throw in the towel when equity market volatility becomes too great to stomach. Our own analysis of academic and industry literature suggests that investors are prone to bailing out of portfolios that have incurred one or two years of losses.

To be clear, an appropriately diversified portfolio should carry just enough market risk to achieve an investor’s return objectives—and no more. Investment risk is something that should be measured, managed, and carefully considered up front in an investment plan—not something to react to after the fact, in knee jerk fashion.

Poor Timing, Poor Performance

Similarly, a number of studies indicate that the average equity investor dramatically underperforms the market as a result of poor market timing decisions. Indeed, DALBAR’s data show that in the 20 years ended in December 2011, the average equity investor dramatically underperformed the market (as represented by the S&P 500® Index). This is directly attributable to poor market timing decisions—a pitfall more diversified investors tend to avoid.

Staying the Course

Here is where diversification comes in—based on available research, it turns out that investors in well-diversified asset allocation and target-date portfolios have lower abandonment rates1 and do better2 than those outside of such portfolios. In an analysis of investor behavior in retirement plans in the aftermath of the 2008 Financial Crisis, Morningstar found that those in well-diversified target-date funds “bucked a fund-industry trend in which investors tend to pull their money at market lows and chase investments close to their peaks.”3 Essentially all the research we have seen on this topic supports the conclusion that well-diversified portfolios encourage shareholders to stay the investing course despite the vagaries of the market.

Holding Period

To put a finer point on it, reacting to market volatility by selling in the face of volatility or bad news means that the average investors does not remain “invested for sufficiently long periods to derive the benefits of the investment markets,” according to DALBAR. Further, the report says that:

“The result is that the alpha created by portfolio management is lost to the average investor, who generally abandons investments at inopportune times, often in response to bad news. In 2011, as in years past, [systematically diversified] asset allocation (including target-date funds) fund investors have remained invested in their respective funds longer than equity or fixed-income investors. Investors’ tendency to hold asset allocation funds longer is a strong case for their inclusion in an investor’s portfolio.”

To be clear, we talk here about investor behavior in asset allocation strategies and retirement plans as a proxy for diversified and non-diversified portfolios. We cite these reports because they contain the most recent and objective data on the subject.

Whether you build your own portfolio of uncorrelated assets or choose a professionally managed and diversified asset allocation fund is up to you. The point is not how you get there. After all, your portfolio is likely to be a unique reflection of your own goals, risk tolerance, and other life cycle and financial considerations. The point is simply that effective diversification in the manner discussed in Diversification 101 can mean better risk-adjusted performance; a less volatile return pattern; better cumulative returns over time, other things equal; and lower abandonment rates and greater likelihood of sticking with an established investment plan. We believe that is a strategy worth striving for.

Rebalancing: Sell High, Buy Low

There is another way in which a diversified approach can improve the timing of investor buy and sell decisions, and that’s through the process of portfolio rebalancing. Step back for a second and think about diversification—at a high level, it’s a process of spreading assets within and across asset classes in a way that is likely to maximize your likelihood of sticking to your investment goals and objectives over time. You (or your financial professional) create a well-thought-out strategy weaving together all the aspects of your financial life to create a finely tuned, broadly diversified portfolio.

But as financial markets move—and in recent years they’ve moved around quite a bit—those carefully selected asset weightings and relationships get out of balance with your intended targets. Putting those weightings back in balance is called “rebalancing,” in which you sell winning assets and buy those that have underperformed. Let’s use a real-life example from 2008 to illustrate rebalancing in action. In 2008, stocks plummeted while government-backed bonds enjoyed one of their best years on record. We know from studies of investor behavior during the crisis that many equity-only investors sold stocks and abandoned their savings plan at this point.

Contrast that behavior with a diversified investor (with demonstrated lower abandonment rates and longer holding periods) who stuck with their overall strategy and rebalanced their portfolio at the end of the year. Because stocks performed so poorly relative to other investments, they would now be underrepresented in our diversified portfolio, while bonds would be comparatively overrepresented because they’d done so well. Rebalancing to predetermined weightings would mean you were selling bonds after a historic rally and buying equities after a historic sell-off. The contrast with investor behavior cited in the DALBAR and Morningstar studies could not be more stark. In no uncertain terms, then, systematic rebalancing enforces a disciplined buy-low, sell-high strategy that is central to a sound investment plan.

At American Century Investments, we believe strongly that investors would do well to adhere to a disciplined, diversified, long-term investment approach. Future pieces will address various aspects of diversification, among other topics.

American Century Investments® offers a wide variety of stock, bond and asset allocation funds. Visit americancentury.com for more information: Individual Investors | U.S Investment Professionals

Download a PDF of this post.

1 Equity Abandonment in 2008–2009: Lower Among Balanced Fund Investors. John Ameriks, Ph.D.; Jill Marshall; Liqian Ren, Ph.D. December 2009

2 Burgess + Associates, “Outcomes of Participant Investment Strategies 1997-2006,” Study Commissioned by John Hancock Retirement Plan Services, October 2007.

3 Morningstar Fund Analysts, “Target-Date Investors Stick Around, Earn Better Returns,” Fund Spy, March 16, 2010.

Diversification does not assure a profit nor does it protect against loss of principal.

This information is not intended to serve as investment advice; it is for educational purposes only.

Investment return and principal value of alternative investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

Due to the limited focus of alternative investments, they may experience greater volatility than funds with a broader investment strategy. They are not intended to serve as complete investment programs by themselves.

The performance results provided here are hypothetical, and are only used for illustrative purposes.

Hypothetical performance results should not be considered indicative of any actual performance results, or any results that could be attained by clients.

The opinions expressed are those of Rich Weiss and are no guarantee of the future performance of any American Century Investments portfolio.

Previous Article

Does the Rally Still Have Legs? (Lee)

Next Article

Time to Exit Emerging Markets? (Koesterich)

Related Posts
Subscribe to AdvisorAnalyst.com notifications
Watch. Listen. Read. Raise your average.