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Delusional Diversification: The Flawed Logic of Using Multiple Advisors

Posted by Chris Holman on Nov 30, 2010 1:50:00 PM

“Put all your eggs in one basket…and watch that basket.”…Mark Twain

There’s a population of affluent investors who, in a vain effort to achieve portfolio diversification, hire multiple financial advisors to mitigate their portfolio risk. Not only is this effort wrong-headed and risky, but it may contribute to the exact condition these investors wish to avoid.

The research we’ve seen indicates that 70% of individuals with portfolios in excess of $1 million use an advisor, and 34% of this population employ multiple advisors. Anecdotal evidence is telling us that this number may also be increasing, as affluent investors attempt to counter the increasing volatility of market conditions.

The psychology of having multiple advisors would seem to be an extension of basic asset allocation principles. Investors reason that if allocating investments across a diverse portfolio is sound advice, why not extend this thinking in order to get a diversified array of “expert” investment opinions?

Unfortunately, there’s a fatal flaw in this logic.

This flaw can be illustrated by considering a hypothetical case study. Let’s consider an individual who is due to retire in one year. They are interested in developing an efficient income plan and tax strategy that takes all of their variables into account. Their assets consist of multiple IRA’s from past employers, a substantial 401(k) with their current employer, as well as a taxable account. Of course the location of each account is important in this calculation. IRA’s are tax-deferred and offer unlimited investment options. 401(k)s are also tax deferred but have more limited investment choice. Personal accounts are fully taxable and have virtually unlimited investment options. When one apportions an investment portfolio among the different asset classes, e.g. stocks, bonds, cash, real estate, alternatives, etc…there is a risk/reward trade-off between these various asset classes. Moreover, when one is retiring, another level of complexity is added because withdrawals may be taken into account. At this point, the investor must decide where and how much to hold in certain types of investments, as well as deciding what accounts should be sold and in what amounts such that the marginal tax bracket is minimized each year.

Given this scenario, it is nearly impossible to expect that a disparate group of advisors working at different firms could develop an efficient communication plan that avoid pitfalls like: portfolio overlap, security concentration, or a less-than-optimal asset allocation, or other equally serious risk factors. The fact is that most affluent investors lead complicated lives anyway. Investors who work with with multiple advisors add a layer of complexity that is, at best, troublesome and, at worst, needlessly perilous.

On top of all of this, post-financial crisis, affluent investors are quite clear on their new investment priorities. In the 2010 World Wealth Report:

  • 79% of high-net-worth investors indicated that “greater transparency and simplicity around products, risks, fee structures, portfolio reporting, and performance” was important to extremely important.
  • 81% of HNW investors were highly desirous of “scenario analysis on the proposed allocations/products aligning to individuals’ goals/expectations.”

So...affluent investors are telling us that they want simplicity, greater transparency, and a scenario analyis that aligns to their goals and expectations. However, if they have hired multiple advisors...this is unlikely to happen! Multiple advisors cannot assess risk properly because they hold only partial information and cannot estimate the outcome of their choices upon the entire portfolio. Financial decisions made without a broad-view perspective, are risky and can lead to asset overlap, higher tax brackets, and poor portfolio performance.

For financial advisors who have clients with multiple advisors, the good news is this. By virtue of having many advisors, the client is most likely saying that they want to reduce their portfolio risk. In which case, it is incumbent upon the advisor to show them a better way to accomplish this.

By the way, today, November 30th, is Mark Twain’s birthday. It is the irony of ironies that he has said, “Put all your eggs in one basket…and watch that basket.” Although Twain was a very successful author and speaker in his lifetime, he was a hapless, hopeless investor. He bankrupted himself by funding the Paige Compositor, a beautifully engineered typesetting machine that never came to market due to the perfectionist nature of its inventor. Over a 14-year period, from 1880-1894, Mark Twain invested $300,000 in this device (equal to $7.5 million in inflation-adjusted dollars), which was the bulk of his book profits plus a good portion of his wife’s inheritance. You can laugh and grin at Mark Twain’s most quotable quotes, but never follow his investment advice.

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