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Why don't stock investors diversify?

(MoneyWatch) Given the obvious benefits of diversification, why do investors take uncompensated risks by failing to hold highly diversified portfolios? This failure has its roots in two distinctly different reasons: lack of knowledge and human behavioral traits.

Because most investors haven't studied financial economics, read financial economic journals, or read books on modern portfolio theory, they don't understand how many stocks are needed to build a well-diversified portfolio. Similarly, investors typically don't understand the nature of how markets and stocks behave in terms of risk and reward (which can also be thought of as the issue of compensated versus uncompensated risk). The result of this lack of knowledge is that most investors hold portfolios with assets concentrated in relatively few holdings.

Let's now examine the other source of the failure to diversify -- human behavior. We will begin by examining the all-too-human characteristic of overconfidence.

Overconfidence kills

Professors Richard Thaler of the University of Chicago and Robert J. Shiller of Yale University have noted that "individual investors and money managers persist in their belief that they are endowed with more and better information than others, and that they can profit by picking stocks." This insight helps explain why individual investors don't diversify: They believe that they can pick stocks that will outperform the market.

Investors also think they can time the market (so that they're fully invested when it is rising and out of it when it's falling) and identify the few active managers who will beat their respective benchmarks. Even when individuals think that it's hard to beat the market, they're confident that they'll be successful.

There are other behavioral explanations for the failure to diversify. That's the subject of tomorrow's post.