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Q&A: Is it Dangerous to Have All Your Money in One Place?

June 2011

Lab Rat

Q: Hi, Mary Ellen,
I’m thinking of consolidating some old 401(k)s and putting all the money in one firm. The salesman pointed out how convenient it would be—and I can see that might be true—but is it safe for me to have all my money in one place? —Theresa

A: Hi Theresa,
That’s a great question! Consolidating your money can make life easier, but it does carry some risks.

First, there is the risk that your bank or financial service provider fails: the recent failures at Merrill Lynch and Lehman and AIG, showed that even large institutions can be brought down by hard-to-predict mistakes. Between 2008 and 2010 over 300 US banks failed and were taken over by the FDIC and other regulatory agencies. The good news was that most investors who held accounts at these institutions emerged unscathed, though with plenty of nervous moments and inconvenience. The lesson: holding money (such as cash savings) in more than one institution seems like a good way to protect yourself but massive crises often take down so many firms that in the end one has to rely on protections such as government-backed Federal Deposit Insurance.

But too much consolidation can also create opportunity costs. Bank and money managers count on lazy investors and savers who won’t walk a half a block for a good deal. Just a few weeks ago two banks on the same block in my neighborhood, TD Bank and Brookline Bank, were offering CDs of similar maturities that varied in annual percentage yield (APY) by almost a percentage point. It really does pay to shop around. Technology can make all this much easier: sites like bankrate.com let you compare rates across the country; online banks compete fiercely for your dollars. It’s easy to link accounts, so why not take advantage of the magic of the Web to earn extra interest and still have the money there when you need it?

Fund Nepotism Can Hurt Your Portfolio

Second, there are the more common, serious and avoidable risks associated with investing through a single money manager. The Bernie Madoff fraud is an extreme example, but even smaller missteps by perfectly reputable money managers can have outsized effects your portfolio.

It’s not unusual for investors to stay with a single fund family, such as Dodge and Cox or Pimco (to name just two very good companies) but that is generally a bad idea no matter how solid the money manager. Fund managers at the same company often have offices next door to each other, go to the same conferences, listen to the same in-house analysts and generally share a similar investment outlook. Not surprisingly, they find themselves owning many of the same stocks or bonds in the funds that they manage.

I recently worked with a client who owned a half dozen American Funds—supposedly to create a diversified portfolio. American uses multiple sub-managers to avoid (in theory) some of the problems of group-think. Yet my client used Morningstar’s ‘stock intersection’ portfolio tool and discovered that all but one of the funds held the same top stocks in proportions large enough to make the funds behave like clones of each other. A similar situation hurt investors in several popular Dodge and Cox funds that bet heavily on financial service giants such as AIG—only to face disastrous losses in the credit crisis of 2007–2008.

This NY Times article tells the saga of investment giant Fidelity’s 1990s foray into bond fund management. Fidelity’s aggressive corporate culture and research strategies had worked well in the stock market, but backfired badly in bonds: In 1994 almost every Fidelity bond fund suffered unprecedented losses as a result of risky bets on derivatives and emerging market bonds. Investors who held only Fidelity bond funds got killed.

Too Big to Succeed?

Achieving fund family diversification can be hard when 401(k) providers cling slavishly to one or two top money management firms. California based Pimco, for example, has been hugely successful marketing its bond funds through a wide array of 401(k) providers—so much so that it is now almost impossible to avoid Pimco if you want a bond fund in your employee retirement plan. Yet Pimco’s management style is geared towards making big bets using derivatives coupled with massive moves in or out of entire bond sectors (as of March 2010 the firm owned no US Treasuries in its flagship Pimco Total Return Fund). Pimco’s strategy has worked wonderfully for many years, but the company’s massive size might now make such moves harder to execute and its ubiquitous position puts millions of investors at risk if this high-risk style suddenly goes out of fashion.

Index Fund Managers Can Make Mistakes Too

Even in the world of index fund investing, there is some theoretical risk in staying with just one money manager. Some mostly passively managed index funds also employ active strategies that use futures contracts or other derivatives designed to reduce transaction costs or enable better execution on trade. Vanguard has been a pioneer of such strategies and they have generally worked very well.

Should any of these strategies backfire, however, they would likely affect almost every index fund the company manages.

It is also perfectly possible to imagine a situation where a massive computer failure or block trading error causes mispricing. A single day of mispricing (such as occurred during the “flash crash”) is easy to correct; but a system-wide programming error affecting something as basic as execution of dividend reinvestments might take months or years to detect and might be almost impossible to rectify in a way that was fair to all investors.

There are now plenty of good index funds managers so that you can diversify not only by investment (large company vs. small company stocks, US vs international); but also by money management firm. (See article on The ABCs of Index Funds and ETFs for links to several top managers)

Diversification 3.0

Q: Mary Ellen, This is starting to sound pretty complicated! How can I protect myself without going crazy?

A: Just follow these simple steps:

  1. All the above fine points aside, the most important source of investment diversification is holding some stocks, some bonds and some cash, with the proportions determined by your near, medium and long-term financial needs. Get that part right and you are about 70 percent of the way towards wealth and security.
  2. Avoid “fund nepotism.” If all of your mutual funds have the same last or first name you are asking for trouble. Even if most of your accounts are with a financial supermarket like Fidelity or Schwab, you can still own funds managed by many other companies.
  3. Use tools like Morningstar to analyze your portfolio and make sure that your funds are still doing what you want them to do: providing true diversification at a cost low enough to allow you to keep most of the dividends and interest.
  4. If you do decide you are over-concentrated in any way, consider all the costs before you make changes.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Past results are not indicative of future performance. Outside sources used in this article are believed but not guaranteed to be accurate. Examples provided are for illustrative purposes only and are not representative of intended results that a client should expect to achieve.