A new study finds that first-time investors are failing to diversify their assets, and thus putting themselves at greater financial risk.
These investors may be better off, he says, picking stocks at random instead.
Diversify your portfolio.
You needn’t be an investor to be familiar with the oft-repeated maxim.
In just about every context, the idea is to avoid concentrating all your efforts and resources in one area so that you’re not vulnerable to losing everything.
But a new study co-authored by Yakov Bart, an associate professor of marketing at Northeastern, suggests that inexperienced investors are failing to diversify their assets, and thus putting themselves at greater financial risk.
His advice for investors looking to play the stock market game is to stop putting so much thought into their stock picks.
“The fundamental way for any investor to minimize risk is to diversify, to invest into uncorrelated assets, which is basically the way to hedge your bets in order to minimize potential losses,” he says.
“Amateur investors would be better off picking stocks at random because that would reduce the likelihood that whatever you pick is going to be positively correlated with each other.”
While Bart’s advice may seem anxiety-provoking at first—especially to an amateur investor—it is grounded in research he and his colleagues conducted in which they asked participants to create portfolios of financial assets using tables of previous returns as a guide.
In assessing the participants’ level of financial literacy, the researchers found that less experienced investors tended to choose “positively correlated assets,” or stocks that typically move in unison (such as oil and forestry stocks).
To novice investors, such stocks look simple and predictable, and therefore appear to be a safer investment. The problem is, these stocks can also potentially plunge in tandem.
“Naive investors feel that by investing into things that look less complicated, or more familiar and predictable, that that seems to them like a safe choice,” Bart says.
“But, in fact, it’s exactly the opposite of a safe choice because it minimizes diversification. If you have a combination portfolio of assets going in all different directions, it seems kind of unpredictable, it seems riskier, but in fact it mitigates your risk.”
Ironically, the study found that when they were encouraged to make riskier choices, the participants actually succeeded in creating portfolios that were more diversified and lower-risk. And when they were shown the aggregate returns of portfolios (instead of on an asset-by-asset basis), the participants were able to see their mistakes.
Bart hopes that the study sheds light on the importance of financial literacy. He says that while technology has made it easier than ever to play the stock market, financial literacy has lagged.
He advised first-time investors to take advantage of resources offered by the Consumer Financial Protection Bureau. But lawmakers and employers should also step it up, he says.
“Policymakers need to pay attention to and put more effort toward increasing their efforts to educate people, to raise financial literacy, so that people understand diversification,” he says. “This mistake in our study was committed by only participants who had low financial literacy; others were able to diversify well.”
Written by Khalida Sarwari.