One of everything can be hard to balance

November 15, 2012 Categories: Portfolio Corner
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Who doesn’t like a buffet? There are so many food choices and even for a picky eater like me I know there will be something I like. I start filling my plate with a little bit of everything, but by the time I get to the end of the line my plate is overloaded and in complete disarray. Meatballs are mixing with strawberries, prime rib is piled onto my salad…will I even eat half of this? I would have been much better off being more selective and getting the right items and portions on my plate, but I just didn’t put enough thought into it.

For many, investing is like being confronted with a massive buffet. Most investors understand that a mix of investments is a good thing. In that sense, the diversification message has certainly worked. However, they are using a “give me one of everything” approach, also known as naïve diversification. In a DC plan, some participants are looking at the investment menu and equally weighting all of the options available.

But for some investors this is creating riskier portfolios by unintentionally being overweight or underweight equities or other asset classes. Research1 shows that when there are more equity options in an investment menu, participants have higher allocations to equities, and the same is true in the reverse when there are more fixed income options, participants have higher allocations to bonds.  Just like my buffet plate that is loaded with too much meat! There needs to be more balance, so that when participants choose to diversify in this manner, they aren’t getting too much of one thing.

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The “do it with me” participants are those that like to be involved with their investments, but want guidance.  Our belief is that good options for these investors can be risk-based funds and/or a limited core menu of asset class funds.  The core menu should be limited so that participants are guided towards an optimally diversified portfolio and not one that puts them in a situation that may compromise reaching their retirement goals. In order to manage the risk, we see an ideal core menu being constructed of 3-8 options. There is no magical number but it could look something like: Cash, Diversified U.S. Equity, Diversified International Equity, Diversified Bond and Alternatives/Real Assets.

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This way the asset class “portions” are controlled in a way that uses the participant investor behavior for their own good and there is less “bad food” to choose from. If they apply naïve diversification to the limited menu, they are likely to get closer to a balanced, 60/40 type of portfolio.

Some ways you can get started:

1)      Streamline the menu; it might be helpful to collapse style funds and remove sector funds

2)      Introduce broad asset category names

3)      Discuss multi-manager solutions; reducing options doesn’t mean reducing diversification

I don’t need ten different entrees…but if you put it out there on the table, I may think I do. The concept is the same for a streamlined menu: consider not offering investments that may not be the best for participants to choose. For many DC participants, their employer sponsored plan may be their only savings vehicle. Smarter plan design can help make these plans work harder for their benefit.

 

1Shlomo Benartzi and Richard Thaler “Heuristics and Biases in Retirement Savings Behavior” (2007) Journal of Economic Perspectives, Forthcoming

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