Less-experienced investors are failing to diversify their assets, according to new research.
Researchers from the University of British Columbia’s Sauder School of Business asked people to create portfolios of financial assets. Participants were tested on their financial literacy and given tables of previous returns to guide their decisions.
Individuals who scored low on the financial-literacy tests were likely to make unwise investments. In particular, these investors chose to put their money into “positively correlated assets,” or stocks that typically move together.
“An amateur investor might buy stocks in lumber, mining, oil and banks, and believe they are diversifying because they’re investing in different companies and sectors,” study co-author David Hardisty, an assistant professor at Sauder, said in a statement. “But because all of those equities tend to move in unison, it can be quite risky, because all the assets can potentially plunge at the same time.”
The authors predict that some of these inexperienced investors would be better off picking stocks at random. And when asked to create a portfolio they perceived as risky, amateur investors actually made safer choices.
“This shows that amateur investors rely on a definition of risk that greatly differs from the objective definition of portfolio risk,” said Yann Cornil, another study co-author and assistant professor at Sauder. “This can lead them to make objectively low-risk investments when they intend to take risk, or to make high-risk investments when they intend to reduce risk.”
The importance of a diverse portfolio
“If you don’t diversify, when one asset does well the other ones are also going to do well,” Hardisty said. “But if one does badly, it’s likely the others will all do badly — and in investing, you want to avoid those worst-case scenarios.”
“In the best-case scenario, you could make lots of money and have an extra vacation or buy a car or something like that,” he continued. “But if your whole portfolio crashes, you could risk losing your life savings. So the best-case scenario isn’t that much better, but the worst-case scenario is a whole lot worse.”
Stock-market participation is rising again
The number of younger Americans choosing to put their savings into the market is lower than it was before the Great Recession. Only 37% of Americans under the age of 35 invest in the stock market, down from 52% in 2007 before the crash, according to a 2018 Gallup poll.
But there are signs that attitudes are shifting: Stock ownership among young Americans reached a low of 33% in 2013, but has climbed slightly since then.
The number of Americans 35 and older who invest in stocks has also risen recently. For the past two years, approximately 61% have had some savings invested in the stock market. Only 58% did two years earlier, Gallup found.
Investing early can pay off
Young Americans who put some of their savings into the stock market early will benefit in the long run if they do it right.
One advantage of investing at a younger age is time. A $10,000 investment at age 20 will grow to approximately $70,000 by age 60, according to the investment blog Investopedia. That same $10,000 investment at age 30 will yield only $43,000 by age 60 — a $27,000 difference.
Investing early also gives young Americans more experience with the financial world at a young age. This knowledge could help them make better decisions when they’re older and the stakes are higher.