The Power of Diversification

As a savvy investor you know that one of the keys to long-term success is avoiding unnecessary costs. You know to steer clear of tax penalties, excessive transaction costs, and even opportunity cost.

But there's another cost that many investors are paying. And according to a recent study, it's caused them to lose more than $1 trillion in unrealized gains.¹

Hendrik Bessembinder, a finance professor at Arizona State University, calls it the cost of "being human." It's the urge to chase winners and dump losers, to do something when the market is not moving in the direction you'd like.

These proactive investors tend to pile into narrowly focused funds that have delivered market-beating returns in the past. This puts the managers of these funds at a double disadvantage. Not only is it difficult for them to continue making winning guesses in their niche, but their fund becomes flooded with cash at exactly the wrong time—when their stocks have risen in price.

And when investors see signs that the fund will not repeat its past performance, they flee, forcing the manager to sell stocks when they are down.

The study, which Professor Bessembinder co-authored, looked at returns of more than 7,800 stock mutual funds over a thirty year period ending in 2020. They found that the typical fund averaged an annual return of 7.7% over three decades, after fees. However, fund investors earned only 6.9% annually over this period, because of their chronic compulsion to chase performance. 

In other words, they paid a 10% premium for "being human."

Other studies have found that a relatively small percentage of stocks account for most of the market's gains. This means that the more stocks you own (through funds) the greater your chances of benefitting from these rare super-performers.

In fact, research has shown that, on average, a mutual fund's performance correlates positively with the number of different stocks it owns. For example, mutual funds holding at least 100 stocks outperformed those with fewer than 50.

The practical investor knows that picking the next big winner is like finding a needle in a haystack. Rather than betting against impossible odds, it's much better to buy the whole haystack. That way you're guaranteed to own the needle.

Reach out to our Participant Success Center if you have questions about diversification and how that can help prepare you for future uncertainty.

 

1. http://go.pardot.com/e/91522/beat-the-stock-market-58e8bd83/96hk15/2726857357/h/F5rwm1xQfK-F0v7G1AkSuzqb6sioCAIULsRT5tRgdPg