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The Hidden Danger of Over-Diversification: Why 401k Plan Sponsors Must Demand Fiduciary Advisers Teach Employees When Too Much is Too Much

The Hidden Danger of Over-Diversification: Why 401k Plan Sponsors Must Demand Fiduciary Advisers Teach Employees When Too Much is Too Much
September 04
00:34 2019

Aristotle said “The virtue of justice consists in moderation, as regulated by wisdom.” No where is this adage more appropriate than in selecting investments from a 401k menu. Plan sponsors might feel their job is done once a robust plan menu is provided to employees, but it’s really only the beginning.

A 401k plan is like a rope – a lifeline – to a safe and comfortable retirement. Plan sponsors must remain mindful they may just be giving employees enough rope to hang themselves. For all the good we’ve experienced in encouraging employees to save more, all that hard work evaporates over time should employees make poor investment decisions.

And the temptation to “do-it-yourself” only grows as the employee’s retirement assets grow. While a Qualified Default Investment Option may offer some protection, that aegis disappears once the employee seizes control of the wheel.

Education, then, can be viewed as “the ounce of prevention” that avoids the need for the cure for employee investment mistakes.

Some of these mistakes are obvious. Others are quite stealthy. It’s up to experienced fiduciaries to reveal these most hidden dangers to employees. And it’s up to 401k plan sponsors to make sure fiduciary advisers offer education programs that meet this objective.

One of the most overlooked of these investment perils is what’s known as “over-diversification.”

We all know the advantages of diversification.

“Diversification is when you invest in a variety of assets whose fluctuations in value are not highly correlated with each other,” says Michael Foy, Senior Director, Wealth Management at J.D. Power in New York City, “so if one or more of them declines sharply in value due to business or economic events, losses will be offset or at least limited by other assets that perform differently.”

Mutual funds themselves have long been marketed as a low-cost alternative entry-level investment. By pooling many investors together, they are able to achieve a broad diversification that ordinary investors could not possibly do by themselves. This helps smooth investor returns by removing some of the more extreme elements of downside risk.

“Diversification is not putting all of your eggs in one basket but instead spreading your investment over different asset classes – stocks, bonds, and cash for example – as well as different investments within those asset classes, such as domestic and international companies and companies of different sizes,” says Greg McBride, Chief Financial Analyst at Bankrate.com in Palm Beach Gardens, Florida. “Proper diversification reduces the risk in your portfolio and increases the odds that your portfolio will grow over time with fewer sharp downturns.”

The concept of diversification began within the realm of stock portfolios. As mutual funds became more popular, many naïve investors simply translated that concept directly. This is where the hidden danger lies. “You can have too many funds when you begin to get overlap in the funds you hold,” says Urban Adams, an investment adviser, Dynamic Wealth Advisors in Orange County, California. “That is, more than one fund holds the same or similar underlying stocks. Multiple funds do not always mean diversification.”

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Having too many funds can lead to any number of investing mistakes. “The most important mistake to avoid is ‘replication,’” says Ken Rupert, Founder of Financial Black Belt Academy in Hampstead, Maryland. “Replication is buying multiple mutual funds that mirror one another in the top ten holdings. This is a common mistake that novice and even some seasoned investors make. If you hold two or more mutual funds where the top ten holdings are exactly the same or very similar, you are setting yourself up to magnify any losses those stocks may incur.”

This is why it’s vitally important for employees to understand more than just the simple objective and class of the mutual funds they own. “Having multiple mutual funds holding similar investments is a sign that you are holding too many mutual funds,” says Michael Zovistoski, Managing Director at UHY Advisors in New York City. “When the investments inside the mutual funds are aggregated in a portfolio and the aggregate shows that the same investment is in multiple funds and the total investment in a single stock is over 5% of the total portfolio, you may have too many funds.”

When this happens, the employee is said to be “over-diversified.” “Over-diversification is when the investor has so many investments that the risk of loss exceeds the risk of gain,” says Zovistoski. “The investor no longer owns only the best opportunities, but also owns the worst opportunities as well. The non-optimal stocks will have a dragging effect on the overall portfolio performance.”

The bottom-line is employees may be setting themselves up not only for failure, but for a costly failure. “You end up paying for something that is not helping you,” says Georgia Bruggeman, Founder of Meridian Financial Advisors, LLC in Boston, Massachusetts.

When it comes to choosing how many mutual funds employees should invest in with their 401k assets, they should be mindful of these words from Aristotle: “It is best to rise from life as from a banquet, neither thirsty nor drunken.”

Moderation in the number of mutual funds is good. Over-diversification is downright dangerous.

Would you like to learn more on over-diversification? Read this 5-part series beginning with “7 Deadly Sins Every ERISA Fiduciary Must Avoid: The 4th Deadly Sin – Overdiversification,” (FiduciaryNews.com, October 25, 2011)

Christopher Carosa is a keynote speaker, journalist, and the author of  401(k) Fiduciary SolutionsHey! What’s My Number? How to Improve the Odds You Will Retire in Comfort, From Cradle to Retirement: The Child IRA, and several other books on innovative retirement solutions, practical business tips, and the history of the wonderful Western New York region. Follow him on TwitterFacebook, and LinkedIn.

 

Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada.

About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA

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