If there’s one investing tenet that’s repeatedly shoved down every investor’s throat, it’s the importance of diversification. Being diversified is good for your portfolio’s health. It’s the third leg on your three-legged stool that keeps you from falling when the market gets wobbly. Yes, diversification limits your upside, but losing money when you need it the most is worse.
To those reasons, you can add another: Diversification is a public good. That’s the conclusion of research published in the Journal of Finance, which found that all investors are better off if everyone diversifies their holdings. Thanks to that diversification, resources are distributed in the most efficient way possible, lifting the economy, markets and ultimately investor portfolios. The trouble is we’re psychologically inclined toward non-diversification and the less we diversify, the less our peers want to diversify, too.
[See: 9 Psychological Biases That Hurt Investors.]
Individual risk-taking raises the economy’s risk level. When investors take on excessive risk, they increase the risk level of the economy as a whole. This drives us to higher highs and lower lows because as the saying goes, the higher you climb, the farther you have to fall.
Our tendency to throw risk aversion to the wind increases when the economy is thriving. “Risk tolerance tends to be procyclical,” says Jon Swaney, co-head of strategic asset allocation and solutions at New York Life Investment Management in New York. “Investors are generally more willing to take financial risks when they feel secure in their jobs, have growing equity in their homes and see stock prices rising.” All of which happens in the expansion stage of the business cycle when unemployment is low and the economy is booming.
As the business cycle climbs toward its peak, investors pile on the risk, stretching stock valuations and fueling inflation. “When the turn does come, the collective pool of risk capital dries up just when the economy needs it the most,” Swaney says. Suddenly, we’re falling as fast as we were climbing before.
Investors herd into risky assets. Humans are herd animals, and for investors, “herd mentality is clearly a risk,” says Mindy Rosenthal, national managing director of the PNC Center for Financial Insight in Millburn, New Jersey. Driven by the need to “keep up with the Joneses” or a fear of missing out on the next big thing, investors herd into risky assets because they see others doing it.
The droves who flocked into Bernie Madoff’s Ponzi scheme are a perfect example; so is the rise and fall of cryptocurrencies. “People tend to get irrationally exuberant and very scared together,” Rosenthal says.
And nothing brings out irrational exuberance like family gatherings. “The largest bitcoin exchange in the U.S. — Coinbase — added about 100,000 accounts around the 2017 Thanksgiving holiday (to a total of 13.1 million Coinbase accounts), much of it due to social interaction between family members at the Thanksgiving table,” says Florian Ederer, assistant professor of economics at the Yale School of Management. When we see our peers making a profit without us, whether on bitcoin or something else, we jump on the bandwagon, even as it trundles straight for a cliff.
[Read: Why DIY Investing Is Risky.]
We can herd for the good, too. But just as we can each contribute to the rise in economic risk through our individual portfolios, we can also choose not to by staying diversified and resisting the inclination to herd into risky assets. “More stable diversification across risk assets, if maintained by a sufficiently large portion of the population, would presumably lessen economic volatility,” Swaney says.
The key words here are “sufficiently large.” As an individual investor, you may feel like a drop in the economic bucket — and you are. But a single drop can create a far-reaching ripple effect. “Social interaction can have positive effects by influencing peers to invest more responsibly,” Ederer says. Research (including Ederer’s) shows that investment in assets with particularly attractive risk-return profiles increases when friends and coworkers also invest in these assets, he says.
Imagine how differently things might have been if those Thanksgiving table conversations were about how Aunt Thelma would reduce portfolio risk by rebalancing before year-end.
By virtue of our own responsible investment decisions, we encourage those around us to invest more responsibly. They in turn influence those around them, and so on, until a “sufficiently large portion of the population” has been affected. A more diversified economy is a more stable economy, and voila: Everyone benefits when you make responsible investment decisions to improve your portfolio health.
Your self-interest can also be for the greater good. That self-interest starts with a selfish desire to not become one of the sheep in the risk-taking herd. When others are herding into risky assets, take a step back and ask yourself if that investment is right for you. “The best way to prevent falling victim to [herding] behavior is for investors to do their own research,” Ederer says.
“Before investing in something, it’s important to know how the investment fits into your overall portfolio,” Rosenthal says. “The investments support a strategy that should take your goals and challenges into consideration and bridge them to planning solutions that will help you achieve your life goals and long-term financial well-being. This is not something your peers will likely have insight into.”
Even if the Joneses are convinced bitcoin is the next great thing, what’s right for their portfolio, may not be right for yours.
[See: 7 of the Best Stocks to Buy for 2018. ]
“Fighting the inclination to blindly follow other investors is wise. So, too, is the act of prudently diversifying one’s portfolio,” Swaney says. “Self-interest alone is reason enough to do these things; if a public good should follow, all the better.”
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The Right Kind of Herding Behavior Lifts All Portfolios originally appeared on usnews.com
