ETF Investors Behaving Badly: Diworsification

Can You Be Too Diversified?

Investing is a bit like walking a tightrope between risk and reward. Investors try to find the sweet spot that maximizes their returns while minimizing their risks. But sometimes, in their quest for a balanced portfolio, they end up making mistakes. A common mistake is called “diworsification,” which means adding investment products to your portfolio in a way that succeeds in increasing risk without getting much in return. In this blog post, we’ll dive into the issue of diworsification among Canadian ETF investors, seek to understand why it happens, and discuss ways to fix it.

 

Exploring Diworsification

Diversification is a fundamental concept in modern portfolio theory. It means spreading your money across different types of assets to lower your risk.  The goal is to reduce risk and potentially increase returns by minimizing the impact of any single asset’s poor performance on the entire portfolio. However, diworsification takes diversification to an extreme, where investors add too many assets with similar characteristics, leading to unnecessary risk without a corresponding increase in returns.

 

There are various causes for diworsification. Impulse investing, where investors make hasty decisions based on tips or emotional reactions, often leads to the addition of assets that don’t fit with their overall strategy. Sector overweighting, favouring one sector excessively, is another common pitfall. When investors bet heavily on a particular sector, they accumulate similar assets with high correlations, defeating the purpose of diversification. A classic example is the Canadian love affair with banks.

 

For my part, I suspect it reflects the inevitable human bias toward action. The expression, “leave well enough alone,” doesn’t sit well with most of us. There is always something more that can be done. This bias leads an investor with a well-diversified portfolio to add just a bit more to U.S. equities because they’ve done well recently. Next, because retirement is approaching and income will be needed, the decision is made to purchase a Canadian dividend equity ETF. And to juice those income flows a bit more, the investor buys a REIT ETF, devoted to Real Estate Investment Trusts. But wait. Those tech giants have been doing so well recently. Maybe the best choice is to worry less about dividends than growth. And so, an ETF that tracks the NASDAQ is bought.

 

If there is a saying that needs to be memorized by every investor, it is this:

 

“Investing is Like a Bar of Soap. The More You Handle It, the Smaller It Gets.”

 

In other words, stop tinkering.

 

A Solution to Diworsification

Diworsification goes against the central principle of modern portfolio theory, which aims to optimize the allocation of assets in an investment portfolio. Institutional investors have access to sophisticated tools and models for achieving this optimization, but even they can fall to the siren call of performance chasing, especially when they have to answer for their performance every quarter.

 

The clue to resolving diworsification lies in determining an appropriate long-term investment policy and sticking with it. That might involve handing off your investments to an expert in the field. That “expert” could be as simple as finding a single ETF that fits your purposes and sticking with it. Investment advisors can also play a crucial role in helping investors build optimized portfolios. Those who manage investment portfolios cannot only recommend the appropriate investment or combination of investments for your needs, but they can also offer rebalancing services to maintain the allocation you have agreed on.

 

For financial planners like me, who deliberately choose not to be licensed to sell specific products, the value is in understanding your investments in the context of your larger financial concerns, recommending an asset allocation that meets those concerns, and knowing that our fees have nothing to do with the investment products you choose to invest in.

 

Robo advisors build their services on modern portfolio theory to recommend managed investment portfolios based on an individual’s risk profile. While their options may be limited compared to institutional tools, that happens to be their saving grace in that the funds they offer are packaged strategically to eliminate diworsification.

 

The Encouraging News

The encouraging news is that individual investors can adopt strategies to mitigate diworsification. One approach involves adhering to recommended asset allocations based on risk tolerance. An investor’s personal timeline is a major factor in deciding the degree of risk one should take. So much so, that a common rule of thumb is to put 100 minus your age in equities (stocks) with the balance in fixed income (bonds). Someone who is 30 years old would, therefore, put 70% in equities and 30% in fixed income. Following the same pattern, someone who is 65 years old would put 35% in equities and 65% in fixed income. This is, in my opinion, a bit crude as rules of thumb go, but it might be a helpful starting point. It is at least an indicator that as you approach retirement and have to consider withdrawing from your accounts, some portion should be put in assets that are less prone to dramatic swings in value.

 

Investors can categorize themselves according to their objective capacity for risk, subjective ability to assume risk, and financial need for risk. Professionals have access to assessments that are increasingly founded on sophisticated psychometric research, but these tend to be costly for individuals. Instead, you may want to try Vanguard’s Investor Questionnaire. The questionnaire on the Vanguard Canada site is being updated, but you can also use the Vanguard questionnaire on their U.S. site.

 

Target-date retirement funds are another way to automate investment decisions and take the temptation to tinker out of an investor’s hands. However, they are mostly limited to the mutual fund space and predominantly accessible through employer-sponsored defined contribution pension plans.

 

Investors should always consider the correlation of new investments with existing holdings. A new asset may appear attractive individually but if it doesn’t offer any significant advantage when its correlation with other investment assets is considered, then there is little point in pursuing it.

 

I am a big fan of the all-in-one asset allocation ETFs that were initiated by Vanguard a few years ago and quickly followed by BlackRock’s iShares and BMO’s ETFs, among other providers. You get all the diversification you need and aside from overweighting Canadian equities in recognition of their investors’ presence in Canada, they follow a market capitalization approach. One fund gives investors all the exposure to the world’s investment markets that they need.

 

Anticipating a Brighter Future

Addressing the tendency toward diworsification can only be positive for investors. By recognizing the problem and taking steps to resolve it, investors can improve the risk-return trade-off in their portfolios. They can align their investments more closely with their financial goals and risk tolerance, leading to a more successful and satisfying investment experience.

 

As the financial landscape evolves, with ETF providers offering funds with increasingly narrow and esoteric niches, investors need to recognize that the fundamental building blocks of portfolio construction are really quite simple. Avoiding diworsification is just one piece of the puzzle. ETF investors will do well if they stick with a few low-cost funds that provide global exposure to the markets. Sticking with theoretically sound and empirically proven strategies will help a lot more than tinkering around in search of the next dubious “big thing.”

 

 

Note: For the next few weeks, I am going to be travelling in Japan, where I spent 10 years of my life, where my wife is from, and where our children spent part of their growing-up years. Blog posts, if I put out any, may take on a bit more of a travelog style.

 

This is the 214th blog post for Russ Writes, first published on 2023-09-11

 

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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.

 

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