7 Deadly Sins Every ERISA Fiduciary Must Avoid: The 4th Deadly Sin – Overdiversification

(The following is one of a special five part series meant to be shared by professionals and non-professionals alike. This particular series covers only one of the 7 Deadly Sins Every ERISA Fiduciary Must Avoid.)

Gluttony (in the ecclesiastical world) – We all need the basic necessities of life. Face it, we all have to eat. But, what happens every Thanksgiving when we eat too much? We get really bad stomach aches and waste the rest of the day sitting on the couch watching lopsided boring football games.

Gluttony (in the investment world) – overdiversification (the act of taking too much of a good thing to the point where the benefit of that good thing is nullified.)

Too Much of a Good Thing Often Isn’t

The excitement leading up to the field trip far exceeded the actual event. The three hour drive to the Ontario Science Center seemed two hours too long. Even crossing the Canadian border proved less dramatic than billed. No security guard searched the bus. The students didn’t have to exit the bus and go through customs. It was as if the border agents took one look at the four busloads of raucous tweeners and concluded the best option was to quickly release them upon their intended destination.

Despite the growing tedium, one exhibit stood out as the primary target for this troop of seventh graders. They had heard tales from older classes about it. Their teachers had promoted it. It remained the only possible lifesaver in what was fast becoming a gloomy monotony. As the buses discharged their prepubescent fares, their eyes widened in anticipation. In a few shorty moments, they would find themselves face-to-face with the monolithic computer, their digital foe in a game of Tic-Tac-Toe.

But what the children learned all too quickly any neophyte programmer could tell them – it’s impossible to beat a computer at Tic-Tac-Toe. Game after game the junior high-schoolers tried. Game after game they either lost or tied. One by one they left the exhibit, disillusioned, depressed and disheartened.

No wonder one heard a collective sigh of disappointment when the chaperon announced the group had to go see the chemistry demonstration. Onward the pack of pre-teens trudged in a dark sterile room with antiseptic plastic seats gazing upon a small stage containing a simple lab table, a few elementary apparati and a man wearing a white lab coat busily making balloon animals. His inane smile only succeeded in lower expectations even more.

Before the audience settled to a respectful silence, the faux scientist (no one expected the real thing) asked for a volunteer to hold one of his balloons. He then proceeded to pull out a pin and plainly popped the unsuspecting inflatable. The unsuspecting volunteer snapped back. So did the rest of the spectators. But he got their attention.

“Welcome to the science lab!” he declared. And so began the presentation.

At one point, the showman filled a balloon with propane and asked the onlookers if they minded if they would mind if he popped it. The gleeful student body, always up for random acts of destruction, gratefully acceded to his request. Being a scientist (it turned out he was the real thing), he explained scientists never do anything the easy way, so, rather than using a pin to puncture the propane filled orb, out from under the table he pulled a blow torch and lit it. He pushed the flame close and the balloon instantly disintegrating into a whoosh of flame. And the fans cheered.

“But, wait!” said the scientist. “Let’s do an experiment. Let’s fill a balloon with 90% propane and 10% oxygen and see what happens.” And so he did. Again he brought the flame to the suspended rubber globule. This time, rather than a calm whoosh, the balloon burst with an audible blast. This excited the crowd more.

Next the scientist increased the oxygen content of the balloon to 50% and asked everyone to cover their ears. The ensuing explosion echoed throughout the room. The man in the white lab coat could sense the gallery hungered for more. He summarized the experiment so far. “With no oxygen, we got only a whoosh,” he began. “With a little oxygen we got a good pop. And with more oxygen we got a rip roaring blast. Shall we try a balloon with 100% oxygen? Do you think that would blow the sides out of this room?”

The American guests applauded for more. After all, if adding oxygen produced a bigger and bigger detonation, mere calculation would suggest a balloon of pure oxygen just might tear the room apart. Without a care for their own safety, they all immediately thought the same thing: “Cool!”

So the scientist filled a balloon with oxygen, lit his blowtorch and as he brought the flame closer and closer, the audience gasped in expectancy. A flicker of flame touched the thin skin and then…

…pop.

Not a “Pop!” just a “pop.”

The scientist had successfully conned the naïve minds into falling for a quick extrapolation. They failed to realize oxygen just increases the rate of burning, it does not itself burn. The kids got snookered, but they understood why. For many, it was a lesson well taught, and for the author, it’s one that resonates four decades after the actual event.

The Man Becomes an Investor

And what better way to introduce the 4^th Deadly Sin – Overdiversification. In this series of installments, we’ll discover how diversification, whose objective has been to reduce overall risk, has over the decades morphed into overdiversification and has actually increased risk.

It didn’t have to be this way. The sense that individual investments carry more or less risk than other individual investments goes back at least as far as the 1830 Massachusetts court decision, Harvard College v. Amory. You may not remember the case, but you’re probably familiar with its lasting outcome. It is from this case that we get the term “Prudent Man Rule.” We’ve already discussed the roots and impact of this case as it pertains to the Prudent Man Rule (see “How the Fiduciary Discovered What’s Wrong With Emphasizing Income,” Fiduciary News, May 25, 2011), but here’s the rest of the story.

While we previously discussed the specifics of the case as it pertains to the investment income objective, here we speak to the practical implications to the philosophical generalities of the Prudent Man Rule. Specifically, let’s look at how this “Rule” evolved since its inception. At its inception as an artifact of Harvard College v. Amory, the Prudent Man Rule required trustees to choose investments “how men of prudence” would. In practice, this meant using the diversification of the greater portfolio to allow for “imprudent” investments. In other words, an investment normally deemed imprudent if purchased as a sole investment could be considered prudent within the context of a broader portfolio strategy.

Initially, the Prudent Man Rule still prohibited the investment in speculative or “too risky” investments. However, the Rule evolved over the centuries. Today, an investment considered “too risky” as a sole investment can be bought if a diversified portfolio offsets its specific risk. We now refer to this not as the Prudent “Man” Rule but the Prudent “Investor” Rule (not to be confused with the Uniform Prudent Investor Act, which is a whole different thing that actually mandates trusts be diversified).

We can best summarize the history of the Prudent Investor (nee “Man”) Rule with this old English Proverb “Don’t put all your eggs in one basket.”

Ahh, if only stayed within the quaint confines of antiquated trust law. Suffice it to say, it did not. We’ll explore how things went right before they went wrong, leading the sin of overdiversification to spread like one of those annoying computer viruses. You may not find “overdiversification” in the dictionary, but you’re likely to uncover it in nearly every 401k plan today.

Part I: 7 Deadly Sins Every ERISA Fiduciary Must Avoid: The 4^th Deadly Sin – The Overdiversification
Part II: A Trip Down Memory Lane – Revisiting Portfolio Optimization
Part III: Overdiversification and the 401k Investor – Too Many Stocks Spoil the Portfolio
Part IV: Why Overdiversification Matters to the ERISA Fiduciary
Part V: How Plan Sponsors Can Help 401k Investors Avoid Overdiversification