Most individual investors are poor investment portfolio managers
Investors more easily understand investment costs that are directly measurable, such as fees deducted on investment statements. However, many investors ignore or are unaware of the “opportunity costs” of their sub-optimal investment behaviors. Opportunity costs are usually much more difficult to measure directly, but these investment costs can be even higher than more visible investment fees.
The opportunity cost of being poorly diversified can be quantified under certain circumstances. While sub-optimal diversification costs can be difficult or impossible to anticipate for individual portfolios, investors can look at studies of large investor populations for guidance on the size of investment opportunity costs. The study, “Equity Portfolio Diversification” by Alok Kumar of Cornell (now at U. Texas at Austin) and William Goetzmann of Yale is particularly useful in providing investors with an indication of the scale of the opportunity costs incurred by poorly diversified individual investors.1 (See also this related article about this study: Is the average individual investor portfolio well diversified?)
Professors Kumar and Goetzmann analyzed over 40,000 discount brokerage equity investment accounts with over $2 billion in total assets for the 1991 through 1996 period. The equities purchased by these investors tended to be in large consumer products and technology companies with well-known names – many of the same firms that constitute the S&P 500 index.
The vast majority of these individual investors’ portfolios were very significantly under-diversified.
On average, the portfolios of investors in this study held four stocks in 1991 and 7 in 1997. About 25% of accounts held only one stock, and about half held one or two stocks. On a risk-adjusted basis, this lack of diversification was quite costly to these investors. When compared to the broad market portfolio, 80% to 90% of these investors’ portfolios underperformed the market over the period of the study.
In a typical sample month, 83% of portfolios with only one to three stocks underperformed the market, while 72% of portfolios with seven or more stocks underperformed the market. Average portfolio performance overall was suboptimal, but when a portfolio was less diversified, performance was even worse.
While Professors Kumar and Goetzmann do not report specifically on the dollar impact of the suboptimal diversification strategies of these individual investors, it is possible to get a rough estimate of the opportunity cost to these investors. Professors Kumar and Goetzmann used statistical methods to compare the [...]