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How Plan Sponsors Can Help 401k Investors Avoid Overdiversification

November 03
00:18 2011

(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.)

Orson Welles created Citizen Kane, believed by most cinephiles to be the greatest motion picture of all time. Only twenty-five years old when he made this masterpiece, Welles reputation rose to that of a (then) modern Mark Twain. Such 1094649_75728294_baby_chick_and_eggs_in_a_basket_stock_xchng_royalty_free_300was the genius of Welles that his stature alone filled every scene he appeared in. Later, a markedly larger Welles filled the screen in other ways. The obviously obese Welles was left to lament, “Gluttony is not a secret vice.”

Unfortunately the deadly sin of overdiversification too often lays hidden from the average 401k investor. Overdiversification, however, is no secret to the academic researcher and the well-informed investor. As long ago at 1997, Better Investing – a magazine for amateur investors – published the article “Don’t Carry Diversification Too Far.” That piece said “Depending on which research study is cited, students of investing generally agree that 12 to 16 carefully chosen stocks will bring most of the benefit of reduced risk that can come from portfolio diversification… There is only so much risk that can be diversified away. No matter how many additional stocks or industries are added, the risk inherent in equity investing will remain; and often the more stocks held, the harder it becomes to best the market averages.”

Plan sponsors and 401k investors must pay attention to the article’s summation: “There is a point at which diversification can move away from being a prudent action and become a limiting factor to further success.” The two important phrases in this sentence are “prudent action” and “limiting factor.” The DOL has repeatedly cited the need for 401k plan sponsors to act with prudence and to consider all factors. Overdiversification is one of those factors ERISA plan sponsors seeking to reduce fiduciary liability must consider.

Plan sponsors have two options to help 401k investors avoid this sin. The first remains wholly within their control. The second relies on the employee.

In the first case, the one that puts the 401k plan sponsor squarely in the driver’s seat, the plan sponsor can nip this sin in the bud. Ultimately, the plan sponsor is responsible for the options available in the plan. This includes the specific make-up of mutual fund choices. Here, the plan sponsor can instruct the investment adviser to focus on diversified funds containing fifty or fewer holdings. This doesn’t mean limiting the plan to funds with only fifty holdings, but it does imply reducing the number of funds with hundreds of holdings. (Note, this only applies to actively managed funds as, by definition, index funds will have hundreds of stocks.)

As part of this effort, the plan sponsor must insure there are only a limited number of options (at least three) and that each option represents a diversified portfolio. Diversification here refers to sector, industry and market capitalization. The objective is to permit the 401k investor to avoid selecting more than one mutual fund to achieve diversification. (We’ll leave the subject of diversification among asset classes for a later discussion.)

For example, a “bare bones” plan could contain just three options: a stable value option; a 50-stock diversified “value” equity fund and a 50-stock diversified “growth” equity fund. This way, even if the 401k investor succumbs to the “naïve diversification strategy” discovered by Benartzi and Thaler, there’s little chance of overlap between the three options and, with only 100 stocks held between the two equity funds, there remains a reasonable possibility for the employee to do better than an index fund.

Bear in mind, this simple example could represent just one tier of a three tier plan. In a three tier plan, these three options could be for one type of employee (one that wants some choice but isn’t a do-it-yourselfer), a series of index fund options could be a tier for another type of employee (one who wants a broad variety of choices and who is a do-it-yourselfer) and a series of default investment options could be a tier for a final type of employee (one who just wants to be automatically invested and doesn’t want to make any decision). Of course, there may be other behavioral finance issues with the second tier and the arena of default investment options has proven to be thorny issue unto itself. Finally, what’s to prevent employees from tier hopping in a manner not intended by the plan sponsor or the plan’s investment adviser?

This brings us to the plan sponsor’s second tactic to help 401k investors avoid this sin. A well-articulated and easily understood education program offers a vital alternative for plan sponsors who want to reduce their fiduciary liability. These programs require plan sponsors to engage investment consultants who are familiar with this sin and how it manifests itself in the 401k investor’s decision making process.

In addition, plan sponsors should demand the periodic reports summarizing plan options include number of holdings and the percentage of top ten holdings for each fund. Since these reports are designed for and shared with employees, the inclusion of this data will give 401k investors the ability to quickly assess overdiversification. Does the fund have more than 50 stocks? Does the fund have hundreds of stocks? If the fund has less than 50 stocks, what percentage of the portfolio contains the 10 largest holdings of the fund? Ideally, the education program would walk through these questions and discuss the range of answers while emphasizing the ideal.

When Washington birthed 401k plans, the intention of providing three distinct investment options meant to address the then prevailing wisdom that, for all practical purposes, the world consisted of only three asset classes – stocks, bonds and cash. The idea was to diversify among asset classes (indeed, the remnants of that original language can still be found in some DOL publications). At first, it was thought each distinct option could be mapped to each asset class, but it didn’t take long to realize “distinct” equity formats could occupy two of those slots (e.g., growth and value). Soon, financial rocket scientists invented ever more “distinct” equity formats and financial service providers were too glad to sell these products.

By 2006, it was determined the situation had evolved to the detriment of the 401k investor. For the most part, regulators felt 401k investors were being too cautious in too many ways (including by not even participating in the plan). The 2006 Pension Protection Act, in part, addressed this with default options designed to serve as a viable single fund option for the disinterested employee.

At the same time, the sin of overdiversification seeped into the decision making of the 401k plan investor. Naïve diversification strategies using too many options created a no-win situation for the 401k plan investor. Based on recent discussions on various 401k fiduciary-oriented LinkedIn Groups, it appears a growing number of investment advisers have concluded the best route for most 401k investors is to select a single diversified fund and plan to hold it for the long term.

If this sounds like plan sponsors should limit fund options to “target date funds,” it’s not. Any single diversified fund with a limited number of underlying holdings will do (and also offers the possibility of an extended track record). In a sense, allowing 401k investors to select only one option with 50 or so stocks seems to fly in the face of conventional wisdom. That’s because conventional wisdom only appears conventional because it’s the result of decades of aggressive advertising. Alas, repeating an error, no matter how many times it’s repeated, doesn’t change its fundamental incorrectness or the results of academic studies showing focused portfolio managers tend to perform better. The idea of focusing your resources on a few well researched ideas isn’t new. While trying to climb out of his personal bankruptcy in 1893, Mark Twain, in The Tragedy of Pudd’nhead Wilson, wrote:

Behold, the fool saith, “Put not all thine eggs in the one basket” – which is but a manner of saying, “Scatter your money and your attention”; but the wise man saith, “Put all your eggs in the one basket and – watch that basket!”

Part I: 7 Deadly Sins Every ERISA Fiduciary Must Avoid: The 4th 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

About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA

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