Read this article today and found its potential implication on portfolio construction interesting. Perhaps there is psychological tendency that pushes us toward adding complexity:
Picture a bridge made of Legos. One side has three support pieces, the other two. How would you stabilize the bridge?
Most people would add a piece so that there are three supports on each side, a new study suggests. But why not remove a piece so that each side has two supports instead? It turns out that getting people to subtract — whether a Lego block, ingredients in a recipe or words in an essay — requires reminders and rewards, researchers report April 7 in Nature.
This default to addition isn’t limited to assembling blocks, cooking and writing. Rather, thinking in pluses instead of minuses could well contribute to modern-day excesses such as cluttered homes, institutional red tape and even an overburdened planet, says behavioral scientist Benjamin Converse of the University of Virginia in Charlottesville. “We’re missing an entire class of solutions.”
I didn’t read the full article, but I don’t doubt that there is more of an instinct to add to a portfolio than to subtract. The beauty of the 3-fund portfolio (or a one fund balanced / life cycle portfolio) is its simplicity and completeness.
There are other factors besides psychology that lead to complexity, though. If you have a paid advisor, they will likely build a needlessly complex portfolio to make it hard for you to self-manage or to demonstrate that they are working hard for the money you’re paying them. Selling off an unnecessary fund often incurs capital gains tax. Tax loss harvesting also often requires adding a fund. These last two issues have meant that I have more funds than I’d like.
I recall there being a number of papers indicating that effective diversification requires an astonishingly small number of investments in practice, around 10 if I remember correctly, even if the portfolio is individual investments (i.e. not funds). Funds make this easier to achieve but I still find it noteworthy how low the portfolio complexity threshold is to achieve almost all of the benefits of diversification in the abstract. There is a significant degree of correlation across all asset classes, so it makes sense that there will be a heavy correlation overlap after the portfolio reaches a certain small size regardless of what you add to it if the initial components are well-chosen. At which point, no additional "diversification" will convey a material benefit, just unnecessary complexity.
Of course, diversification is a hedge against some kinds of risk but not others.
Sometimes there's no choice but to have clutter, for example fund companies arbitrarily having Developed & Emerging products. I wish there were more global funds.
