I'm a grown-up; I'm not special

"What makes you special?" asks the hiring manager, with a sneer, of the twenty-something in front of her.

"I'm a grown-up; I'm not special," replies the young woman, and with that one line, lands the job. This scene, from the series Younger, gets right at the heart of much of the second topic in our series of investment mistakes: underdiversification.

Year in and year out, this year's top performers are not going to be next year's stars. Like our friend Nick Murray says, "Just like Miss America, you can only win once." But it's worse than that. You see, picking this year's winners nearly assures you of underperformance. In other words, current high performers are not "special."

Chasing top-quartile performers--the funds that outperformed 75% of the others over the past three years--in hopes that they would continue to outperform for the next three years, fails 98.2% of the time. And for five-year periods, your chances of guessing which investment's past performance might get worse: Only 0.4% of the funds were still in the top 25% of performers, according to Morningstar (1).

Betting the house on any one idea is akin to Russian Roulette: only you never (really) want to win this game. One idea, one bullet.

One of the most common mistakes is to put MORE of your money in your company stock than you already have. This is a huge bet for your family. Even if you cannot see this, and you are sure that you know what's going on, or you're sure that someone in a position of authority above you sees how much you have in your company stock, and will properly reward you for taking on that much risk, please recognize that you are betting with more than your own money. Your children, spouse, and others do not have the same confidence.

Recently, the pay of top CEOs is being disclosed as public companies release their earnings. For many of them, their compensation is more than half (and in some cases 90% or more) in company stock. In all of the high-profile cases, these C-level executives have salaries that already put them in the top 1%, or the top 1% of the 1%, and their financial plans are not like normal people's financial plans. To invest as they do is foolish. Just because Gronkowski can catch a football and pummel Aqib Talib doesn't mean I should suit up and try my luck with the Denver Broncos come August, in the hopes they might lose their senses and hire me. And even if they did, I wouldn't recommend any different advice for a player: diversify.

Underdiversification is the second of the several investment mistakes we see people make. The polar opposite of the one we discussed last week, overdiversification, it is often made for exactly the same reasons: a lack of confidence and/or naiveté. Things are not different. Just because this investment--even if it is your own company stock--has done well, there is no statistical evidence for the persistence of performance (2).

Citations
(1) Morningstar Large, Mid, and Small equity funds and the Fi360 toolkit as of December 31, 2013.
(2) Behavioral Investment Counseling, Nick Murray, ©2008

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