Modern Portfolio Theory saw itspopularity go viral through the 1980s and well into the 1990s. Thiscoincided with the mutual fund becoming the de facto standard ofthe 401(k) option menu.

Can too much of a good thing be a bad thing?

The answer is an unequivocal "yes" when it comes to picking401(k) plan investment options (see "The Hidden Danger of Over-Diversification: Why 401kPlan Sponsors Must Demand Fiduciary Advisers Teach Employees WhenToo Much is Too Much," FiduciaryNews.com, September 4,2019).

To unravel why this is so, we need to go back to Modern Portfolio Theory and a concept known asthe "Efficient Frontier." Without diving too deep into a sea ofstochastics, here's what the Efficient Frontier comes down to:Don't put all your eggs in one basket.

That's right. The best way to remove the extremities of downsiderisk is to diversify away. Despite the name, Modern PortfolioTheory formed through the mathematical analysis of stocks – first individual stocks, eventuallygroups of stocks (called "portfolios").

One annoying fact with individual stocks (as well as certaingroups of stocks) is the unfortunate tendency to producedramatically negative returns. These returns turn out to be anartifact of somewhat regular cycles.

It turns out, if you pair stocks with non-correlated returncycles, the duet's dancing return patterns yield a much lessvolatile form. Since no two stocks are perfectly non-correlated,you actually produce smoother returns by added more stocks to thisburgeoning portfolio.

This is where the idea of "diversification" comes from. Wediversify a portfolio of stocks to create more consistent returns.An optimally diversified portfolio occupies the EfficientFrontier.

It didn't take long for Modern Portfolio Theory to translatestocks diversification into asset class diversification. The muchsought-after non-correlation characteristics between asset classestend to be more pronounced than those exhibited between stocks (or,indeed, any securities within a single asset class).

This is all well and good. It is also from an era before thedominance of mutual funds. Sure, pooled funds existed decadesbefore Modern Portfolio Theory (they were blamed for the 1929 stockmarket crash and their infamy, ironically, spawned the mutual fundvia the 1940 Investment Company Act). Still, Modern PortfolioTheory originally dealt with individual securities.

Modern Portfolio Theory saw its popularity go viral through the1980s and well into the 1990s. This coincided with the mutual fundbecoming the de facto standard of the 401(k) option menu.

The growing dominance of mutual funds made sense. They were easyentry-level vehicles for investors with small amounts of cash. Thisincluded both retail investors as well as the new 401(k) retirementsavers.

As people became more interested in mutual funds, several mutualfund rating services arose. Among them – and the eventual winner –was Morningstar. Morningstar quickly gained fame from itsinimitable "style box."

The style box, based at least in part on Modern PortfolioTheory, soon influenced the very nature of mutual fundportfolios.

Mutual funds portfolios started as fully diversified groupingsof stocks, much in the same way any large personal portfolio wouldbe managed. These multi-cap portfolios, however, didn't fit neatlyinto Morningstar's style box model. For a number of quiteunderstandable marketing reasons, most mutual fund companies shedall but a few flagship multi-cap funds. In their stead theyassembled families of mutual funds, each designed to mimic aparticular square within the style box.

That's when the problems began.

As mutual funds grew in size, thanks in part due to the growthof 401(k) plans, it became difficult if not impossible for mutualfunds to stay "pure" within each style box sector. There weresimply too many assets and too few stocks within any narrow sector.Funds within different style box sectors possessed overlappingstocks.

That, in itself, isn't a bad thing. In fact, it's a form ofdiversification. That's a good thing.

The problem manifested itself when 401(k) participants applieddiversification beyond its original intent – individual securities– to portfolios of stocks, i.e., mutual funds.

This produced an over-diversification, what might better becalled "di-worse-ification." It only took two or three mutual fundsto create what amounted to an index fund. An index fund that had amuch higher expense ratio than one might want to find in an indexfund.

This was a real problem. It was beginning to hurt 401(k)investors. And very few were paying attention to it.

Not a lot of ink was spilled on this problem in the first twodecades of the 401(k) plan. Most perceived a bigger problemexisted. Far too many participants were placing long-term assetsinto short-term funds, usually stable income funds (as opposed tomoney market funds).

In part to combat this trend (as well as to encourage moresaving), in 2006 Congress passed the Pension Protection Act. ThePPA created default investment options, the most popular beingtarget-date funds. These funds were designed to be the one and onlyone investment participants who didn't want to do-it-themselvescould – and should – invest in.

Today, target-date funds are the most popular 401(k)investments. That means most plan participants are investing inonly one mutual fund.

And that's why the 2006 Pension Protection Act accidentallysolved a major problem too few at the time recognized.

READ MORE:

Get them addicted to saving —Carosa

Would rank-and-file 401(k) retirement saversbenefit from working with an advisor?

Fee compression: Bad for retirement savers? —Carosa