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Vanguard: Advice Can Dramatically Improve Investor Diversification

A new Vanguard Research study indicates that advice, both human and algorithmic, can help investors diversify.

Investment advice has become increasingly commoditized due to a number of factors, among them the rise of ETFs and robo advisors, all of which are putting pressure on the price of investment advice and the margins of advisors.

However, according to results from a new survey by Vanguard Research of over 44,000 investors with median wealth between $250,000 and $500,000, improved investment diversification—coming from advice—is contributing to portfolio value.

Cognitive or behavioral biases and a lack of financial literacy, Vanguard said, can cause many individual investors to make portfolio construction errors, which include taking an undisciplined approach to risk-taking, holding on to too much cash and overly concentrating their assets in domestic securities.

Vanguard studied the behavior of investors with a median age of 64 and median tenure with Vanguard of 15 years on its self-directed platform who switched to Vanguard Personal Advisor Service, which adds human advice to the process, and found that their approach to equity risk-taking changed dramatically.

More specifically, it led three out of 10 investors to cut large cash holdings, led over 90% of them to eschew home bias (a focus on domestic securities as opposed to investing in the global market), and reduced or eliminated idiosyncratic risk from holding individual stocks.

While the proliferation of mutual funds and ETFs has helped investors diversify, Vanguard found many investors are still challenged by behavioral or cognitive bias or a lack of investment literacy, which can get in the way of their efforts to diversify.

For instance, investors may misunderstand the risk and return characteristics of asset classes or lack knowledge of portfolio construction techniques, or their decision-making may suffer from inertia, overconfidence or other biases.

According to Vanguard, the value in portfolio creation derives from its diversification, which generates better after-tax risk-adjusted returns net of all fees and matches to the investor’s risk tolerance, and this can be quantified.

The survey found that after getting advice, about a third of respondents made only minor changes to their equity risk-taking, while 39% required either material or large changes to their level of equity risk-taking and the remainder made a substantial change, increasing or decreasing their allocation by at least 30 percentage points.

Professional advice, Vanguard said, is based on “close tailoring of risk levels to investor goals, risk tolerance and time horizon,” which creates “a more attentive or intentional approach to equity risk-taking than investors may take on their own.”

In addition, Vanguard found that getting investment advice from a human and an algorithm has a large impact on reducing “excessive levels of cash.” For instance, before getting advice, three in 10 investors held cash positions representing over 10% of their portfolio assets, while 11% held cash positions of more than 50% of their assets, indicating high levels of risk aversion, procrastination in portfolio implementation and a lack of literacy about fixed income investments. After getting advice, these cash positions fell, with most of the monies being reallocated to bonds, as the average bond allocation rose to 37% from 23% in portfolios.

Further, prior to getting advice, 83% of investors  held 10% or less of their portfolio in international investments. After? The median international allocation rose to 35%.

In addition, after getting advice, nearly all of the investors in the survey eliminated all of their individual stocks. Before, 18% of the total sample held a substantial portion of their portfolio in individual stocks and, within that group, more than half held over 10% of their portfolio in individual stocks, while a smaller percentage held at least half of their assets in individual stocks.

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