man with hands on head looking at stock market ticker

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

The answer is an unequivocal "yes" when it comes to picking 401(k) plan investment options (see "The Hidden Danger of Over-Diversification: Why 401k Plan Sponsors Must Demand Fiduciary Advisers Teach Employees When Too 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 as the "Efficient Frontier." Without diving too deep into a sea of stochastics, 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 downside risk is to diversify away. Despite the name, Modern Portfolio Theory formed through the mathematical analysis of stocks – first individual stocks, eventually groups of stocks (called "portfolios").

One annoying fact with individual stocks (as well as certain groups of stocks) is the unfortunate tendency to produce dramatically negative returns. These returns turn out to be an artifact of somewhat regular cycles.

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

This is where the idea of "diversification" comes from. We diversify a portfolio of stocks to create more consistent returns. An optimally diversified portfolio occupies the Efficient Frontier.

It didn't take long for Modern Portfolio Theory to translate stocks diversification into asset class diversification. The much sought-after non-correlation characteristics between asset classes tend 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 the dominance of mutual funds. Sure, pooled funds existed decades before Modern Portfolio Theory (they were blamed for the 1929 stock market crash and their infamy, ironically, spawned the mutual fund via the 1940 Investment Company Act). Still, Modern Portfolio Theory originally dealt with individual securities.

Modern Portfolio Theory saw its popularity go viral through the 1980s and well into the 1990s. This coincided with the mutual fund becoming the de facto standard of the 401(k) option menu.

The growing dominance of mutual funds made sense. They were easy entry-level vehicles for investors with small amounts of cash. This included both retail investors as well as the new 401(k) retirement savers.

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

The style box, based at least in part on Modern Portfolio Theory, soon influenced the very nature of mutual fund portfolios.

Mutual funds portfolios started as fully diversified groupings of stocks, much in the same way any large personal portfolio would be managed. These multi-cap portfolios, however, didn't fit neatly into Morningstar's style box model. For a number of quite understandable marketing reasons, most mutual fund companies shed all but a few flagship multi-cap funds. In their stead they assembled families of mutual funds, each designed to mimic a particular square within the style box.

That's when the problems began.

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

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

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

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

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 two decades of the 401(k) plan. Most perceived a bigger problem existed. Far too many participants were placing long-term assets into short-term funds, usually stable income funds (as opposed to money market funds).

In part to combat this trend (as well as to encourage more saving), in 2006 Congress passed the Pension Protection Act. The PPA created default investment options, the most popular being target-date funds. These funds were designed to be the one and only one investment participants who didn't want to do-it-themselves could – and should – invest in.

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

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

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

Fee compression: Bad for retirement savers? — Carosa

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401(k) menu: One isn't the loneliest number – Carosa

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