Risk Management Best Practice

Conflicted Advice About Portfolio Diversification

Authors:
Sally Shen, Global Risk Institute and John A. Turner, Pension Policy Center


EXECUTIVE SUMMARY

Investors are often encouraged by financial advisors to “roll-over” their 401(k) into Individual Retirement Accounts (IRAs). This advice is based on the notion that IRAs, which offer a virtually unlimited number of investment options compared to 401(k) plans, provide improved diversification. This work investigates the soundness of this investment advice and empirically analyzes the diversification of a large 401(k)-type plans that offer five basic investment options.

The results of this study show that rolling over from Thrift Saving Plan (TSP), 401(k) or 403(k) plans with many investment options does not generally improve diversification. It follows that the common advice to roll-over is not valid and is often costly, with potential present-value losses in the thousands.

More generally, our results indicate that for participants in large 401(k) plans, which typically have lower fees than small plans and IRAs, it is in fact possible to achieve better diversification by rolling over. However, this advice ignores increased costs. Because the improvement in diversification is generally relatively small, the increase in costs from rolling over to an IRA outweighs the improvement in diversification. In other words, incomplete analysis has led to bad advice: the analysis focuses on only one aspect of the situation, in this case portfolio diversification, without adequately considering costs.

This study also shows that pension plans can be well diversified with a relatively small number of funds. For example, with its five basic investment options, the TSP is well diversified. Adding an additional four investment options results in slightly better Sharpe ratios using some investment strategies. It follows that defined contribution plans and other funds of funds, such as target date plans, can provide participants with the opportunity to have well diversified funds while maintaining simplicity of choice. This result is particularly relevant to litigations focused on the adequacy of the investment options offered by pension plans, where some plaintiffs have claimed imprudent management based on the small number of investment options being offered.

In addition, the results suggest that some financial advisers and some providers of financial products may use strategic complexity to impress naïve investors, recommending or providing complex investment portfolios when simpler portfolios may be superior, once fees are taken into account.


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