- Many investors are overdiversified and hold an expensive tracker fund without realising it.
- There are simple ways to avoid this mistake.
One thing I’ve learned from our reader portfolios is that some of you are overdiversified, holding so many equities and funds that you in effect have a tracker fund.
To see this, think about the basics of diversification. As you add assets to your portfolio you naturally dilute the impact that any one has on your total returns: that’s what spreading risk means. But you increase the significance of the correlations between assets. Because correlations of relative returns are often low, this means that if you hold lots of assets your portfolio can easily resemble a tracker.
Let’s say, for example, that each of the assets you hold has a tracking error with respect to the All-Share index of 20 percentage points – that is, there’s a two-thirds chance of its annual returns being within 20 percentage points of the index’s. Smaller shares typically have bigger tracking errors than this, but general equity funds have smaller ones. And let’s say the correlation of relative returns is zero, so that if one of your assets outperforms there’s a 50-50 chance another will underperform. Then if you have 40 such assets you have a two-thirds chance of your annual returns being within 3.2 percentage points of the index’s and only a 5 per cent chance of beating the index by five percentage points or more. In effect, you have a tracker fund.
Of course, tracker funds are a great idea. But you can buy one directly without the time and trouble of researching and trading stocks. And if you own actively managed funds within an overdiversified portfolio, you are incurring unnecessary management charges.
A tracker fund is a fund of equity funds. It allows you to diversify across all developed market equities with just one fund. Why do so many investors think they need more? One reason is that a single fund just feels too risky. Maths tells us it is not. But maths is mere brain-knowledge. It doesn’t feel right. It’s understandable to respond to your gut feel of uncertainty by adding some assets.
There are however less good reasons why people overdiversify – although there are simple solutions to these. One is the mere passage of time. If you’ve been investing for years you can become overdiversified simply because you’ve bought more shares than you’ve sold. Buying is fun whereas selling means sometimes having to admit you were mistaken. And you’d rather be a buy-and-hold investor than a trader. The upshot of this is that your portfolio comes to look like your garage – full of useless clutter.
The solution to this is to have a disciplined selling strategy. Dumping shares if they fall below their 10-month or 200-day moving average is one such approach, but you need some variant on it.
A second reason we overdiversify is the fear of missing out on a stellar performer. This is dangerous because speculative stocks on average do badly – Aim-listed shares have consistently underperformed the main market since Aim was launched in 1995.
There are antidotes to this. One is to remember that regret is an inevitable part of life. We will always miss some great investments and the only way to get into big risers is to also buy risky junk. Also, if you are widely diversified, a great performer won’t make much difference. One that makes 50 per cent will add only 1.25 percentage points to the return on a 40-asset portfolio. You can make more than that in a half-decent week for the market.
There’s a third reason why we overdiversify, pointed out by Shlomo Benartzi and Richard Thaler back in 1999. They showed that when pension fund investors were offered lots of equity funds but just one bond fund they invested a lot in equities, but when they were offered lots of bond funds and just one equity fund they invested a lot in bonds. Our diversification, then, is determined by what’s available rather than what we need. And because there are thousands of shares and funds available to us, we diversify more than we should.
The solution to this is to consider not what is available but what you need. Imagine you held only a global tracker fund. Then ask: what else might I need to diversify?
There are answers. Listed shares are disproportionately mature ones that have gone ex-growth. You might then consider private equity funds to get exposure to fast-growing companies. Or such stocks might be vulnerable to efforts to decarbonise the economy, in which case you should consider green funds. Or perhaps developed economies will remain mired in secular stagnation, which means there’s a case for emerging markets and frontier funds. Or you might worry that tracker funds hold too many large stocks, and have a small-cap fund to balance this.
Whether you do all or none of this is not the point. The point is that your investments should be determined by what you need, not by what is available. It’s in this context that I’m wary of cryptocurrencies. If these didn’t exist, would you really think you needed an asset to protect you from the risk of a collapse in our current payments systems? No. I suspect that many people buy cryptocurrencies merely because they are there rather than because they genuinely expand our diversification possibilities.
There are, however, tight limits on what we can achieve with equity diversification alone. In really bad times such as recessions or financial crises, almost all shares fall. Mitigating losses therefore requires that we hold assets other than equities, such as bonds, gold, foreign currency or cash – although it is possible that even these won’t hold up as well in future equity bear markets as they have in the past.
Investors, then, should worry less about diversifying within equities – as this job can be done to a large extent by a tracker fund – and more about how to diversify out of them.
