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Our Own Worst Investing Enemy: Putting Our Investments in One Basket

So far this week, we've covered how our behaviors can cause us to believe our holdings will beat the market and how our overconfidence can reduce our returns through too much trading. Now, my Buckingham Asset Management colleague Kevin Grogan will take a closer look at how behavioral biases affect the diversification of the portfolio.

There have been many studies of individual investors' portfolios, and almost all of them find that the typical investor's portfolio contains very few securities. The 1974 study, "Stock Ownership: Characteristics and Trends," found that 34.1 percent of the 17,056 investors studied held just one stock, 50 percent held no more than two stocks, and only 10.7 percent held more than 10 stocks.

You might argue that individual investors were undiversified in the 1970s, but there's too much information available now for this to still be the case. While the picture isn't as bleak as it once was, the 2004 study, "Household Portfolio Diversification: A Case for Rank Dependent Preferences," found that investors today will simultaneously invest in well-diversified funds and a poorly-diversified collection of stocks. Investors seemed to have listened to one half of the lesson but not the other. Alternatively, they may have listened to the whole lesson but can't resist the urge to gamble with their retirement portfolios and make their broker wealthy.

Diversification issues also stretch to the portfolio's composition. U.S. stocks account for only about 40 percent of global equity market capitalization, yet U.S. investors tend to concentrate their holdings in U.S. stocks. In their 1991 paper, "Investor Diversification and International Equity Markets," Ken French and James Poterba found that U.S. investors held less than 7 percent of their portfolios in foreign securities. This phenomenon isn't unique to U.S. investors: the same is typically true of investors in other countries as well. (For further discussion on international investments, see the MoneyWatch video "Why You Need More International Investments.")

Tomorrow, we'll look at how your behaviors affect your retirement accounts.

Follow the series: Our Own Worst Investing Enemy